I recently read an interesting piece which I found gave me a better understanding of some of flaws in the European monetary system, The piece pretends the Euro system is in place in the US and imagines that a ‘member state’, say California, were to overspend under produce, and eventually head towards a bankruptcy or a restructuring of its debts. I've adapted the piece as follows:
Imagine California promises its citizens large pensions beginning at 50, free health care, subsidized education, paid 2-week vacations, and all-you can-eat baklava / ouzo at beachside state parks (a metaphor for a long list of subsidy programs). Further, assume the authorities never come after anyone who doesn’t pay property, sales, or income taxes. When times were good, California issued bonds to pay for all of these goodies, and banks bought them because states cannot default, can they? [In Europe, most of the public debt is owned by the banks (Sovereign Debt), unlike in US where majority of debt is owned by US Government via bonds]
After some time, the banks figured out that California was spending more that it was making, so they stop buying bonds from them. Now, California quickly gets into trouble…..as it doesn't have enough money coming in to pay for all of their needs, so the governor of California heads to the US Congress to ask for money – a bailout. A bailout gets offered, but only in exchange for policy reforms and spending reductions, as other states will not help to pay unless California reforms its failed policies. Yet, these reforms are harsh, and would mean big changes to Californian's!
By now the other state banks are really worried, and beyond not buying new bonds they stop lending any more money to Californian banks, and in turn credit agencies cut California's credit rating - making the problem worse. California citizens now begin to panic and withdraw their money from the California banks (a run) and now the problem grows into a crisis!
Without another alternative, the Governor agrees to the terms of the US Congress, and gets the bailout money. However, the reforms agreed by the Governor fail to pass the state legislature, as the prospect of lower pay and retirement at 55 send Californians into the streets. Because of this the bailout money stops, so the fed-up Californians elect a militant left-wing radical, to lead them out of the mess!
As there is no federal system that has authority over all member states, no one can force California to reform anything - only through the leverage of the bailout money can other states exert influence. Also, as there is no Federal Reserve Banking System
(or in turn FDIC), uniform policies take a long time to come to agreement in, making remedies usually small in scale and painfully slow and sometimes lack being effective as a result. Because of this, not only do California's problems continue, but now other peripheral states (Spain, Italy, Ireland, etc.) with problems worsen.
After some time, the new governor realizes there is no easy way out…..either horrible spending cuts and years of recessions or California can simply default (bankruptcy) , and start a new currency (Drachma's). Californian's realize that their default might cause other states to default also, and may leave a multi-trillion-dollar hole in the US balance sheet, and the remaining, more-responsible US states would have to pick up the tab. So the new Governor goes back to Washington and threatens to exit the union unless the dollars, ouzo and baklava keep coming.
And that’s where we stand with the current fracas in Europe! Without any form of FDIC insurance or national banking resolution authority, Germany and France are being placed on the hook for Greek and other peripheral debts. They are the de facto insurance of the Euro.
We should be thankful that US leaders were smart enough to federalize the banking system, thereby not allowing any individual states to threaten the integrity of our entire financial system. While we have our share of debt problems here in the US, they are federal debt problems and we united states are all on the hook for. For the Euro states, they are united only by common currency, and their individual debts may topple the system like domino's. By the time this goes to print..some of those dominos maybe falling.
Adapted from John Mauldin's, What if California were Greece, an article written by David Zervos.
The article can be found in Thoughts from the Frontline, Meanwhile, Back at the Ranch, May 26, 2012.
Pete Thoresen
Financial Advisor
Focus Financial Network, Inc.
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Minneapolis, MN 55426
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