The PIIGS Are Under Stress

 

February 25, 2010

 

You've probably been hearing a lot about Greece recently, and before that about Dubai--two countries that were in danger of defaulting on what economic geeks call 'sovereign debt,' which basically means their country's equivalent of Treasury bonds.  Dubai's problem was $26 billion in debt issued by Nakheel, its most prominent real estate developer, which was tacitly backed by the government.  Order was restored last December when neighboring Abu Dhabi provided Nakheel with a $10 billion loan.  Greece, meanwhile, has $28 billion in government debt due in April and May, and as you read this, the European Union is debating when and how to come to its rescue.

 

What you probably aren't hearing is that all of the PIIGS (Portugal, Ireland, Italy, Greece and Spain) are having similar troubles, and that in all cases, the problems were visible, and warnings were raised by economists, years before the budget crises came to a head.   According to a report by The Economist, Greece's debt is now up to 112.6% of its gross domestic product.  Ireland's is 65.8%, Spain's is 54.3%, Portugal's is 77.4% and Italy's is 114.6%.  What makes Greece stand out is that suddenly foreign buyers are shying away from its government securities, sending the yield on ten-year notes soaring to 7.1%, and raising the cost of rolling over the debt--sending deficits even higher.

 

Why should we care about the PIIGS?  The fear is that if one country were to default on its debt, it could trigger a Lehman-type domino effect to other countries with shaky economies.

 

Sovereign debt defaults, and the potential for problems in Greece to spread around the world, are a major fear. This issue has undermined confidence, but the ultimate danger to the U.S. economy has been vastly overestimated in my opinion. Greece’s government owes about $400 billion, which is just 4% the size of the $10 trillion U.S. mortgage market. As of yet, we know of no major financial institution, either in the U.S. or abroad, with solvency issues because of Greek debts.

 

Of course, this is not the main issue. Many fear that a Greek default could drive up interest rates for other sovereign debt and in other markets, drive down debt values, and perhaps kick-off another financial panic. Fortunately, the potential for this issue to spin out of control is very small. In fact, there is a very good chance that this entire episode leads to some sanity in government spending and a better, more market-friendly future.

 

As of 2008, Greece had a top income tax rate of 40% and a value-added-tax (VAT) of 19%. In addition, employers paid 28% of salary for social security, while employees paid 16%. The debt issues in Greece have little to do with revenue; they have everything to do with the worldwide inability of governments to spend within their means. The same is true in the U.S. It is not tax rates that are the problem; it is spending that threatens solvency. Just look at Illinois and California. If these states raise tax rates again, more people will leave, hurting the attempt to raise revenue.

 

Even if Greece, Illinois, California or the United States itself repudiated their debt – declared they would make zero payments – they would all still have substantial annual budget deficits. At that point, the only fix would be to cut spending because no one would lend them money.

 

In the end, the only way for Greece and other political entities to fix their budget problems is to cut spending. Politically, this is very difficult. But, in tough times like today, when everyone is feeling the pinch, it is just as hard to convince other (EU or U.S.) taxpayers to bail out the scofflaws.

 

Riddle: Give the names of 2 U.S. state capital cities which rhyme but share no vowels.

 

The fear that haunts U.S. economists is that, at some point, the world's bond buyers will lose confidence that America will ever get its debt situation under control.  It also may be the underlying fear among people who attend the Tea Party rallies around the country.  The real deficit problems in the U.S., however, are not found in government spending, per se, but the amount of money promised to future retirees in various. forms.  Lately, various financial planning conferences have heard presentations by David Walker, former head of the U.S. Government Accounting Office, now president of the Peter G. Peterson Foundation.  Walker gives a terrific speech on how America is executing a reverse transfer of wealth from the younger generation and unborn to the Baby Boom generation.  He does exactly what economists were doing in Greece for twenty years before the meltdown: telling U.S. that the longer we wait to solve the problems, the more likely we are to face an unsolvable crisis.

 

Perhaps the easiest example to understand is Social Security, which was enacted during the Great Depression, at a time when the average person's lifespan was 65.  65 also happened to be the normal retirement year, which meant that most citizens collected no Social Security benefits at all; only those who lived an unusually long time would get back the money that was collected into the government retirement system.  Fast-forward to today, when the average U.S. life expectancy is 78.2 years, and it is not uncommon for people to live to age 100.  The same is true of Medicare; when it was enacted, people were expected to receive benefits for a year or two, not additional decades.  In all, according to "The Complete Idiot's Guide to Economics," 23% of the U.S. budget is spent on Social Security, 12% on Medicare, 7% on Medicaid; recently, Congressman Randy Forbes estimated that mandatory entitlements now represent 62% of all federal spending.

 

We are learning from European countries that spent too much for too long: the solution is not anger or warnings, but concrete action that addresses the real sources of fiscal imbalance--and perhaps most importantly, a willingness to sacrifice our way back to a balanced budget.  Walker proposes means testing for Social Security recipients, arguing that it makes no sense to send government checks to billionaires.  The government will have to ration health care and put it back on a budget.  He tells people what “you” already know, and what Greece and some of its neighbors are learning: it doesn't work any differently for governments than it does for people; the numbers are just a lot bigger.

 

Best regards,

Edward J. Kohlhepp, CFP®, ChFC, CLU

Edward J. Kohlhepp, Jr., CFP®, MBA

 

 

Quote: “We would worry less about what others think of us if we realized how seldom they do.” – Ethel Barrett

 

 

Riddle Answer:  Austin & Boston

 

Compiled from various sources, including Bob Veres & Advisor Perspectives

These are the views of the author, Bob Veres and/or Advisor Perspectives, and not necessarily those of Kohlhepp Investment Advisors, Ltd. or Cambridge Investment Research, Inc.  Past performance is not a guarantee of future returns.

 

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