Friday, February 26, 2010

Life In the Eurozone

Crunch time is soon to arrive for Greece and crunch time is not far off for Spain, Italy, and Portugal. But, that will only be the beginning. There is not a single country in the Eurozone which will not face a debt crisis in the next year or two. They are all vulnerable and all for the same reason: (i) too much government employment and (ii) entitlements.

The correct process is for countries in trouble to simply default. Then they could issue new debt, albeit at pretty high rates and then continue on. That will buy each of them some time.

The other possibility is the dissolution of the Eurozone and a return to national currencies -- the mark, the franc, the lira, etc. This would fragment Europe and reduce its economic competitiveness. But, it will permit countries who want to run their countries responsibly to be free from having to support profligate regimes like Greece. I suspect Germany will, sooner or later, leave the Eurozone. It is certainly in their national interest to do so.

But even Germany cannot survive with its current government workforce and in-place entitlements for retirement and health care. Germany cannot afford their welfare state and will face catastrophe in the bond markets, sooner or later, unless they move away from the welfare state and quickly. The US is in essentially the same situation.

Many folks think that the example of Japan shows that you can run large debts indefinitely and survive. Keep in mind, however, that Japan's debt is owed mostly to Japanese people and institutions. Not much of Japanese national debt is in foreign hands. Not so with the US and some of the sicker countries in the Eurozone. It makes a big difference whether your national debt is mostly held externally or mostly held internally. An internal debt is much like one child in a family being in debt to their sibling. Does this mean the family is in trouble? Yes, but not in the same sense as if one person in a family had a large debt to a person in an entirely different family. So, Japan's situation is actually better than that of the US. Remember that the Japanese have a high savings rate with which to fund their enormous, mostly internal, national debt. The US has no savings and the debt is mostly external and the external percentage is growing.

So, where does this end? It ultimately ends with one of two possible outcomes: 1) a desperate country, Chavez-style (should I say Obama-style) proceeds to nationalize everything and slips into a Soviet-style economic stagnation that will persist indefinitely; or 2) the country will move toward free markets, dramatically curtail government employment and phase out entitlements.

Each country will choose its path. Perhaps, the current fight over "health care reform" is the first skirmish in the coming battle over which way the US is headed -- permanent economic stagnation or free market capitalism.

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