Justin Brennan San Diego Real Estate Blog: January 2012

Solving the Mayan Code

There are so many pieces of data to go through in order to augur Europe's future – I want readers to know I have left no stone unturned! In fact, I went to some very old stones to get help with this week's letter. I began to scrutinize the Mayan Code from ancient Central America, which so many feel predicts the end of the world on December 21 of this year, bringing my fresh eyes to an old mystery.

After much deliberation, I have come to this astounding insight: The Mayan academics who created the code were not in fact astronomers or even astrologers. No, it is clear they were another breed of even more dubious forecasters, called economists. Once you approach the glyphs with that understanding, it becomes clear they are not predicting the end of the world, merely the end of Europe. One symbol clearly shows the Greek flag dipping to the ground. Another depicts the Italian flag with its wheels coming off. Oh, and you don't even want to know what they have prognosticated for the French. This is a family e-letter and I can't squeeze such language past the censors. But now that I have provided the basic insight, I leave it to you, fellow scholars, to decipher the rest of code.

And we will spend our time together here this week trying to discern what it means, in fact, for Europe to come to the place in its journey where it must make extremely difficult and often painful choices. As I wrote last week, as I started this voyage of discovery with you, the choices the various countries in the developed world are now making will put us on a path that does not allow us to turn back without severe consequences. (If you missed last week's letter, here it is.) We are left with debt that must be dealt with, with imbalances that must be balanced, and with deficits that must be brought under control. No matter what we choose, there will be pain for all of us. You cannot make debt go away without paying it back or defaulting, one way or the other, which means someone loses. And as we will see, paying it back can be very difficult, indeed, once it has grown this large.

To Solve the Crisis You Must Solve Three Problems

There are three main problems in Europe. The first is that most of the banks are massively insolvent, because they have 30 times their capital invested in the second problem, which is the sovereign debt of countries that are going to have trouble paying that debt. If the banks have to mark down the debt to what its real value is – or to what it will soon be – they will be bankrupt on a scale that makes 2008 look like a waltz in the park.

Countries simply cannot function in a manner that can be called normal without viable banking systems, which is why the authorities spend so much time worrying about them. If banks can't make loans, then businesses must cut back, which means fewer jobs, products, and services, which quickly becomes an ugly spiral. Losses in the private sector mount up. This obliges the treasury secretary to get on one knee and beg some elected official who has no understanding of how business and economics work to save the world as he knows it.

But if countries must step in and save their banks, then they have to assume some of the losses. (I am assuming that this time shareholders get completely wiped out, as do most bondholders. Taxpayers – read voters –are actually paying attention this time. They are in no mood to bail out bankers.) But most of the countries in Europe with the worst banks simply do not have the money to invest. They already have too much debt. Where do they get the capital? (More on that later.)

For most of the past two years, European leaders have tried to deal with the problems as though they were short-term liquidity problems: "If we just find the money to buy some more Greek bonds, then Greece can figure out how to solve its problems and then pay us back. Given enough time, the problem can get solved."

They have now arrived at the understanding that it this not a short-term problem. Rather, it's a solvency problem of the various governments, which of course creates a solvency problem for their banks. They are now addressing the problem of solvency and providing capital until such time as certain countries can get their budgets under control and the bond market sees fit to provide the capital they need.

But they are completely ignoring the third and largest problem, and that is massive trade imbalances. Germany exports products to the peripheral European countries, which run trade deficits. As I have shown in several letters, a country cannot reduce private-sector leverage, reduce public-sector leverage and deficits (balance its budget), and run a trade deficit all at the same time. That is simple, unavoidable math, based on 400 years of accounting understanding. Ultimately, there must be a trade surplus if leverage and debt are to be reduced.

Greece runs a trade deficit of about 10% of GDP. Until they can stop that bleeding, they cannot get their government and private budgets under control. It is not simply a matter of cutting budgets or raising taxes. Indeed, their economy will continue to shrink, making it more difficult buy foreign goods without increasing their own production of goods and services. It is a vicious spiral. And that same spiral will spin up to take in all of Europe. Again, more on that later, as we consider what their choices are.

But for now, let's start with my contention that if you do not solve all three problems you do not solve the real problem. Greece cannot "stand on its own" without a change in its cost of production relative to Northern Europe. Neither can Portugal, et al., unless Germany either changes how it exports and consumes more, or Germany is willing to fund Greek (and Portuguese and Italian and…) debt, so those countries can continue to run large deficits.

Let's resort to something I have done in the past, and that is to create a simple model to help us understand the issues involved. As always, when we make simple assumptions we are ignoring the real complexities. I know things are vastly more complicated than the following simple analogies, but the underlying truths are basically the same.

Getting Simple About Europe

Let's assume a country that has a gross domestic product (GDP) of $1,000. In the beginning it taxes its citizens about 25% of GDP and spends the money for the public's benefit. But alas, it spends about 30% of GDP, so it must borrow the overage (about $50) from its citizens or from the citizens of other countries. Because the country starts out with relatively little debt, interest rates on this loan are low, because those who buy the debt can easily see that the the country can pay them back. If the debt of the country is only 5% of GDP ($50) and the interest rate is 4%, then the amount that must be paid as interest is only about $2 per year. Not a whole lot, about 0.2% of GDP.

But this goes on year after year. Sometimes the deficits get smaller and sometimes they get larger, depending on the economy; but government expenditures grow at the same rate as the country grows, and the debt keeps growing at an average of 5% of GDP per year. Now, if the country is growing at 3% a year, after 24 years the economy will have doubled to $2,000 GDP. That means the debt has grown (roughly) to a total of $1,800, which is now a debt-to-GDP ratio of 90%. Debt has grown faster than the country's economy. Note that if the country had held its budget down to where it grew slower than GDP, thus reducing its need for debt, that ratio would be lower, even if the debt had grown. You can indeed grow your way out of a debt problem if the growth of government spending is less than the growth of the economy.

But what if the size of government grows to about 50% of GDP, rather than 25% or 30%, over the 24 years, as politicians decide to spend more money and voters decide they want more benefits? (Think France.) Then the private sector must pay about 50% of its production to the state – plus, the debt is now growing unwieldly. The private sector has less to invest in new businesses and tools, and the growth of the economy slows.

And then along comes a very nasty recession. The revenues of the government fall as the economy shrinks. If the economy shrinks by 3% and total taxes are 50%, then tax revenue falls to $970. But the government does not cut back; and indeed, because it must pay unemployment benefits and welfare (because unemployment rises in a recession), its expenses actually rise by 5%! So it now needs $1,050 to pay all its budgeted expenses. And it must now borrow $80 to pay everyone it has promised to pay, in addition to the $100 it was already borrowing every year to cover its deficit, or a total of $180 a year, which is 9% of GDP.

(Yes, I know that debt must change as a percentage over time and nothing is stagnant, but work with me here.)

Now debt-to-GDP is rising by about 5% a year. Not a large number in the grand scheme of things, and everyone knows that the recession will soon be over and the deficits will come down. Sovereign governments never default on their debts – our government leaders assure us of that. They can always raise taxes or cut spending, can't they?

And things rock along just fine, and the bond market continues to buy the debt, until one day you look up and the debt is 120% of GDP. Then the bond market gets nervous and says that instead of 4% it wants 7%. Now the interest payments are over 8% of GDP and 16% of government spending, which means the government must either cut back on services or salaries or benefits, or raise taxes, or borrow more money. But cutting spending and raising taxes have consequences. They reduce GDP growth over the following 4-5 quarters as the economy adjusts.

What if that interest rate cost rose to 10%? Then the interest cost to the government would become 20% of its expenses and be rising faster than the country could grow, even in the best of times. And if they continued to borrow at 7% and the country did not grow, those interest expenses would rise at least 7% a year – as long as interest rates didn't go up.

And what if the other countries who had been buying the government's debt looked at the basic math and realized that, another step or two down the current path of government spending, there was no way they would be able to get their money back?

This first chart shows how much bank debt is maturing in Europe over time. You have to add in how much new debt must be sold, as they will need to raise capital to balance the sovereign debt losses. Do you have a spare €1.5 trillion? Yes, some of that is rollover debt, but banks are trying to reduce their exposure to each other and may not want to roll over that debt, unless they can turn around and get capital from the European Central Bank to buy it, which is a back door to debt monetization.

The next chart shows how much debt must be rolled over by governments in the coming year. Notice how much Italy must raise in the first three months!

And one last chart from Hester. This is the rise in the cost of new debt as older, cheaper debt comes due. My simple example is not at all extreme.

Next week we will look further into Europe. As a preview, I do think this is the year they will be forced to the very hard decisions. We will examine what a fiscal union would look like and how likely it is to happen, and what the prospects are for a break-up of the eurozone, and compare several scenarios for what Europe may look like in five years.

Source for this Blog (By John Mauldin | January 14, 2012)

To all your success,

Justin Brennan

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