The financial pundits and network talking heads are wailing and gnashing their teeth over the news that the Portuguese flagship bank, Banco Espirito Santo, is insolvent and can’t meet its short term paper obligations. The ordinary investor can be forgiven for being confused. The stock market has been going through the roof, and the volatility index has been near historic lows for some time now. I can hear the inexperienced day-traders crying, but the VIX said everything was fine, from here in Connecticut. But of course, the European debt crisis was never over. The symptoms were just managed and disguised by the European Central Bank printing money to buy the sovereign debt of indebted nations. What is very interesting is the deceitful way in which the obviously serious problems facing Espirito Santo were covered up and mislabeled.
Initially, the bank said there was some type of operational problem that impacted payments to its private clients in one of its Swiss operations. This was obviously a non-truth, a spin–or in other words, the bank didn’t tell the truth to the markets what was happening. It lied. It remains to be seen what accountability the bank’s leadership will face regarding this statement. Only a few weeks later did the truth come out that the bank could not meet its obligations and was basically insolvent.
The problem is that Portugal, and the other members of the PIIGS, have not solved the underlying problems that the countries and their banks face. Due to government interference in the private market, the nanny-state economies are not growing fast enough to support the generous payments from the welfare state. The nations are deeply in debt, with debt to GDP ratios above one-hundred percent–which is historically a serious red-flag for the bond markets. There are structural issues that have to be resolved before their economies can grow again. These include labor restrictions, taxation, etc.
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As in America, the Europeans are not paying a market rate for their debt. With the central bank involved as an auction player, the bid for these bonds is artificially high. Therefore, the associated interest rates paid are artificially low. This gives an incentive for governments and bank leadership to avoid or delay dealing with the structural issues. The hard choices can be put off in hopes of “muddling through.”
What the European Central Bank did last year that caused the markets to breathe a sigh of relief is to say that the ECB would backstop the Euro at any cost. This meant buying up state-issued bonds in order to maintain their price levels, shore-up balance sheets, and prevent the banks that owned them from defaulting. Well, now it seems like even this central bank action was not enough to prevent some of the state-owned banks from going under–hence the situation at Espirito-Santo.
It has also been interesting to see the Keynesian reaction to the events in London, where the government of Prime Minister David Cameron has aggressively targeted an austerity program to reduce the debt load of the United Kingdom and basically ensure the country lives within its means. It can’t and won’t work, they have screamed at the top of their lungs. The dirty little secret is that austerity is working in the U.K., to the consternation of the opposite point of view. The English are taking their medicine and will reap the benefits in the near future.
The old saying, there is no free-lunch, rings true today regarding the European debt crisis. Europe, or the United States for that matter, cannot borrow its way to prosperity. In the end, the money has to be paid back. When markets begin to realize that the chance of being paid back is falling, the cost for the borrower will always rise. Central bank intervention only delays and makes worse the inevitable–and creates bubbles in other areas that will burst at some point in the future. No, the European debt crisis is not over. We are only experiencing a lull in the pain to come. That is true for the United States debt crisis as well.
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