Evercore Pan Asset

There are two sensible answers to the Euro crisis. Greece could leave the Euro, devalue its currency, and come to an accommodation with the markets over what it needs to do to enable it to borrow again. That would be the best answer for the Euro. It would enable Greece to take part of the cuts in its living standards through devaluation, as the UK is doing under its own version of an economic policy based on too much state borrowing. Alternatively, Greece could cut its public spending more substantially, until the markets believe it can then afford the debt it needs and already has.

Instead, the governments debate two dangerous answers. They take seriously the idea that Greece should fail to make payments on its debt – a form of government theft from the savers who have in the past supported Greece and believed its promises. That would be bad for the Euro area’s reputation, and lead to more worries about Portugal and Spain. They discuss lending Greece more money on easy terms, based on the idea that the way to sober drunkards is to give them another drink.

I find it surprising that so many governments and Euro commentators expected the Euro scheme to work when they put several economies into it that had not come into line with the performance and costs of the core countries. Writing of the Euro project almost a decade ago I concluded that “Controlling budget deficits is central to this task” of creating a decent currency. It was quite obvious that for the scheme to work member states had to surrender domestic budgetary control to the EU, to avoid free riding by spendthrift countries on the average interest rates or to avoid Greek style disasters. Indeed, in the founding paperwork of the Euro it was spelt out that member states had to keep their stock of debt to 60% of GDP and their extra borrowing each year to no more than 3%. The decision to allow relaxation of these necessary rules has led directly to the Greek crisis.

It was also clear that a country had to bring its private sector costs into line with the zone as a whole as well as control its state deficit. “If you cannot devalue your currency when your costs are too high, you have to sack people and close factories” – exactly what has happened to the olive belt economies.

It does no-one any favours to imply there is a quick fix, or to suggest lending Greece billions this year will solve the problem. The underlying problem is fundamental. The Euro can only work and be a decent currency if there is in effect one state budget for the Euro area. Germany needs to reinforce the rules over how individual members do borrow, not grant an easy loan and watch as Greece still fails to sort out her borrowing habit.

Why does all this matter?

Much of the money lent to governments can be bought and sold daily in the markets in the form of government bonds. This government borrowing usually has the highest rating from credit agencies, or AAA, because investors often believe that money lent to governments is as safe as you can get. Governments, they argue, will pay all the interest owing on time, and will be able to repay the loan at the end of its life without difficulty.

They take this optimistic view for a couple of good reasons. Most governments control their own currencies, so they can always print enough to pay back the money if all else fails. Governments have taxation powers, so they normally lay their hands on large sums from people and businesses resident in their areas to meet the bills. These powers mean governments can normally borrow to pay interest and borrow again to repay expiring loans.

History tells us, however, that from time to time despite these advantages governments do default – they do not pay all the interest or they fail to repay the capital on time. This week rumours about the Greek government’s excessive borrowing and financial difficulties culminated in a Ratings Agency downgrading Greek government bonds to the lowest grade, or junk bond status. This followed a period when investors sold or stayed away from Greek government bonds, driving their price down and demanding ever higher interest rates to reward any new loans to the Greek authorities. Greece is having to offer 21% per annum to borrow money for two years. Spanish and Portuguese bonds are also on the slide, as those countries too are borrowing large sums and the Ratings Agencies are beginning to downgrade them.

Euro members do not control their own currency, so one of the two reasons why investors often think a government will always be able to repay does not apply. Euro zone countries have the added hazard that they can only print the money needed if the Euro authorities agree. Although Greece does have strong taxing powers, her electors seem to be in no mood to either pay more tax or to watch their public spending being cut. As a result the markets are telling the Greeks that they are being unrealistic. This is producing an accelerated crisis where Greece cannot borrow enough money at any sensible rate of interest to be able to carry on as she has been doing. She has run out of money to pay the state wages and benefits. She needs an emergency loan. Sector paper could now become part of the problem for the banks with their own overextended credits. The bonds fall sharply in value in a Greek style meltdown, leaving banks that own too many of them yet again with damaged capital and reserves.

Our forecast is that the Euro zone members will try to keep the zone together. They will late in the day broker a compromise between the need for Greece and the other highly borrowed states to cut their budgets more, and to provide access to loans from other Euroland members with possible extra help and conditions from the IMF. Payment of the money from Germany has been delayed by the unpopularity of this course of action and the impending German elections in May 9th. Everyday which passes without a deal is another day when the markets can pile on more pressure, and widen the assault to Iberia from Greece.

None of this should be unexpected. We have warned for months that 2010 will be the year of a rolling sovereign debt crisis. We hold no sovereign debt in Euroland or UK government bonds in unconstrained portfolios, as we expected price falls. We have no investments in Euroland shares other than the modest proportion of Euroland multinationals contained in world indices where we hold World share funds. We see no need to buy into Euro government bonds or general Euro land share indices as these are risky assets whilst this crisis has further to run. There is no good solution in sight yet. Euroland is reluctant to evict states that cannot meet the requirements, whilst the member states are slow to make the painful adjustments they need to make to stay in. In the meantime expect slow growth and currency weakness.

Sovereign debt losses are also bad for banks, which have bought huge quantities of government paper during the Credit Crunch.