Back in 1999, the primary goal of the euro was to position Europe to better compete with the U.S., but there was also hope that it might lead to economic restructuring in some of the peripheral countries.

Obviously things didn’t go as planned.  Disregard for budget policies among the PIIGS nations (Portugal, Ireland, Italy, Greece, and Spain) led to inflation and, consequently, diminished competitiveness.  And while these nations became less competitive, their debt as a percentage off GDP ballooned. Now there is legitimate risk that these countries will default on their debt obligations.

We’ve known about these problems for a few years, but volatility is higher than before for few reasons.

1. The inability of Europe’s leaders to devise a viable solution and the willingness of indebted nations to get their houses in order. Hard choices need to be made sooner rather than later, yet European decisions makers seem unwilling to fully address their problems.  The current strategy of buying time has increased the costs to stabilize the eurozone and led to a crisis in confidence, resulting in contagion to other countries and a possible banking crisis.

Meanwhile, indebted countries show no evidence of holding to their promises of austerity.  We’ve seen Italy has go back on some of the austerity measures they promised to make.  And Greece just failed its quarterly review for additional bailout funding due to a lack of progress on achieving fiscal targets, implementing structural reforms, selling off public assets, and a public debt swap plan.

2. Europe’s weak starting point for economic growth. The eurozone (the second biggest economic region in the world to the U.S.) grew by just 0.2% in the second quarter on slower global growth and weakness in domestic demand. Europe’s non-existent economic growth is only exasperated by bond markets demanding near-term fiscal restraint.

The poor economic outlook has contributed to global volatility as well.  While the eurozone region (accounting for nearly 20% of global GDP) has not recently been a big driver of growth, a breakdown in economic growth or their banking system would be felt globally.

3. The inadequacy of the eurozone bailout. Policymakers recently beefed up its bailout fund (known as the European Financial Stability Facility, or EFSF) to a lending capacity of €440 billion (or $260 billion).  This is probably sufficient to cover smaller economies like Ireland and Portugal, and even give a little assistance to Spain.  But markets’ attention have since turned to Italy, the third biggest economy in the eurozone, which now makes the bailout facility look inadequate.

The European Central Bank (ECB) has been able to provide some support, most recently by purchasing Spanish and Italian bonds.  However, the ECB’s ability to print money is somewhat limited given that they seem to depend on support from the German public.

4. The European banking system is infected. European banks have large holdings of sovereign debt, which need to be written down, and the banks are not positioned to absorb losses.  European banks also remain highly leveraged, not having recapitalized or deleveraged to the same degree as those in the U.S.   Without getting into all of the gruesome details, the European banking system is horrific.

Credit default swaps (CDS) on European banks are above levels reached in 2008, but the lack of transparency in the CDS market is cause for an entirely different set of concerns.  As we learned when Lehman Brothers went bust in 2008, things can get real ugly if the company selling insurance via CDS on PIIGS sovereign bonds or the banks holding them can’t pay the claim (this was AIG at the time of the Lehman failure).

So what’s the solution?

Policymakers are currently opting for temporary solutions that avoid a sovereign default, mostly because nobody knows the broader implications of a default on European banks or contagion to other PIIGS.  But band-aids can’t cure the patient when surgery is required.

Long-term solutions boil down to a breakup of the single currency or greater fiscal unity among eurozone nations.  A breakup of the euro seems unlikely right now given France and Germany’s recent support of Greece’s participation in the euro currency.  In addition, politicians are generally unwilling to inflict near-term pain, and a euro breakup could result in increased defaults, a banking system recapitalization, and disruption to international trade.

If there isn’t a breakup, then more fiscal unity is necessary and one way of achieving that is issuing Eurobonds that are jointly backed by the eurozone nations.  The idea is that the eurozone’s finances in aggregate are comparable to economies that are currently able to borrow at record low yields.  However, critics argue that debt problems can’t be solved with more debt and there may be a reduced incentive for weaker nations to get their finances in order when they can rely on cheap funding from Eurobond issuance.

There are also enormous legal barriers because, unlike with the EFSF, Eurobonds would require changes to European treaties.  Additionally, there is no guarantee that all nations could convince their citizens to go along with such a plan – Germany, for example, would see a significant increase in borrowing costs with Eurobonds.

We are currently putting together a webinar with a more detailed analysis on the situation and the implications for investors.  Please check the blog later next week for more details.

Peter Lazaroff

Acropolis Investment Management

www.acrinv.com/blog