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EURO IS NOT IN CRISIS. IT'S TIME TO ELIMINATE THIS MYTH

1/10/2012

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For months we are been bombarded with news reports about the crisis of the Euro. In the end we even believe that the Euro is in trouble. We should be very clear: the Euro is not in crisis. Excessive government spending is the culprit of the crisis, whatever currency is used. Outrageous government spending destabilizes the world economy. It does not matter if it is referred to in Euro or Drachma, Pesetas, or Deutschmarks. Let us be clear: European Governments spent money beyond their means. Unfortunately, the Old Continent is not the only one that reserved the right to mortgage the next two generations of citizens’ tax earnings.

While the excessive spending of governments cannot be condoned, time has come to propose a more solid assessment of “sovereign debt”, or the debt owned by the government. The risk of a loan is directly related to the capacity to repay that same loan. While expenses are one side of the problem, revenues represent the other side. The capacity of governments to pay debt, next to cutting expenses, depends on the capacity to generate revenue. There are some short term opportunities like selling assets and privatizing operations, however the key to long term success of balancing budgets depends equally on the capacity to secure tax revenue.

If we wish to assess the capacity to secure tax income, it is important to study first and foremost the accumulated debt of citizens and corporations as a percentage of annual gross domestic product. If the government is overspending, and the citizens are maintaining a solid savings ratio, while the corporations are not leveraging their balance sheet and investing in future activities as is the case with Germany, then there is no reason to worry (too much). If on the other hand consumer credit is at its limits, estimated at 100 percent of annual income, and if companies have leveraged their balance sheet to the extreme, maintaining a debt/equity ration in excess of three for debt and one for equity, then it is obvious that the government has little flexibility but to cut down spending dramatically, cause excessive pains to all members of society and generate social unrest.

I would like to suggest that instead of panicking over the pericles of the Greeks, we should worry over the American triple debt: the federal government plus the states have more than 150 percent of GDP in debt with the State of California hovering on the brink of bankruptcy. As a percentage of GDP, the US federal and state debt is equal to the Greek one. The real crisis of America (and not Greece) is in the huge accumulated debt of the individual Americans. The private citizens have assembled more debt than their total annual income. Greek individuals have but a fraction of the private debt as a percentage of their revenues and have maintained savings rates in excess of debt accumulation, a rather healthy indicator.

Perhaps the worst debt situation is the state of affairs with Corporate America which has leveraged its assets and mortgaged its cash flow carrying a massive debt. The debt has grown to such proportions with the largest corporations and banks, that these are now deemed too large to fail. Hence, business benefits from a safety net provided by the Government, or better said by future earning of its citizens who will be taxed to pay for the irresponsible decisions made by business and financial policies imposed by shareholders. Whereas a debt equity ratio of 3 to 1 is the norm, many companies have  evolved to a ratio of 5 to 1. A 10 to 1 debt/equity ratio is no exception and even tolerated provided that there is cash flow to cover the interest payments. A company like Lehmann Brothers did not even have 3 percent coverage, meaning that its debt equalled 30 and its assets just one! However what is worse, is that publicly held companies that have a healthy one to one ratio will be pressed by shareholders strapped for cash, to either acquire additional assets (complemented with additional debt) or increase dividend pay, draining the money out of the company.

This dramatic triple level of debt (state, corporate and citizen) means that there is hardly any propensity to increases taxes in an effort to reduce government debt. This explains the allergy of Americans towards any additional levies. Everyone is so busy trying to pay off interest on debt that there is no room for additional levies. Whatever can be creamed off is already committed to the financial institutions. Under these circumstances, interest rates are comparable to taxes, the only difference is that these are paid to banks, which are guaranteed their operations through bail-out schemes with government. If citizens and corporations do not pay the interest anymore, then the banks will fold, and the government has to pay the difference - with tax payers’ money. So we are back to square one.

If we assess the European private and business debt (with the exception of the UK), we see a much healthier situation. While we all agree that taxing citizens when the economy slows down is not wise, continuing to bail out the financial institutions, and thus committing tax revenues for approximately two generations to non-productive investments which are not contributing to alleviating social stress in society. The Belgian Government finally reached an agreement on its budget deficit, cutting some €12 billion, but at the same time, it provided €90 billion guarantees to a defunct bank Dexia, compromising the future capacity of its citizens social security. After all the debt accumulated at this magnitude can only paid back by forcing future generations to cough up the cash. The great difference is that in Europe, there is a propensity to impose more taxes, since the capacity to generate income by private individuals and corporations remains strong due to their lack of massive debt. In America, none of that is available. The surprise came when Sweden surpassed America as the highest per capita investor in venture capital stimulating innovation. A country with the most generous social security scheme in Europe shatters the presumption of uninformed protagonists in America that social security in Europe is at the heart of the problem.

So who should we really worry about: the Euro zone, the Greek economy or the Americans? We should worry about them all. However, the latest report on poverty in the USA confirmed that already 24 percent of the population lives below the magic poverty line, and the number of poor Americans has been growing for decades. The American dream does not exist anymore for one quarter of its population. The American dream is the privilege of the one percent that enjoys the wealth of Wall Street. Everyone else is struggling to make ends meet, abate obesity and make end-of-month debt payments. Do you believe that children can imagine a future under these conditions?

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    The aim of this blog is to present a fresh look at realities around us. Whereas I do not pretend to present the truth nor a definite position, I do wish to push the reader to think beyond the obvious. After all, time has come to dramatically improve the plight of millions, and that requires more than the predictable. Sometimes it forces us into spheres of discomfort.

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