Euro bulls need to consider the implications of an EU bailout of Greece or the implosion of Eastern European debt in Lithuania and Latvia. Some are even wondering about the prospects of Euroland itself.

With that backdrop please consider Almunia Says EU Officials Ready to Assist Greece in Budget Plan.

The European Commission “stands ready to assist the Greek government in setting out the comprehensive consolidation and reform program, in the framework of the treaty provisions for euro-area member states,” said Joaquin Almunia, who is in charge of economic and monetary affairs, in a statement late yesterday. He didn’t say what form any assistance could take.

Almunia’s comments come as investors debate whether EU governments would bail out Greece if it was unable to pay its bills. Former German Finance Minister Peer Steinbrueck said in February that euro members would “in reality” rescue states in difficulty. Almunia said yesterday Greece “is a matter of common concern” for euro nations, echoing language he has used since November. He didn’t elaborate further.

“The situation in Greece is very difficult,” European Central Bank President Jean-Claude Trichet said Dec. 7. “We all know the figures, and we all know the very important, courageous decisions that have to be taken to put the situation back on track.”

Greece Government Bonds Tumble

Bloomberg is reporting Greece Government Bond Tumble Fails to Entice Pictet, Frankfurt.

The biggest drop in Greece bonds in more than a decade isn’t enough to entice some of Europe’s biggest fixed-income investors amid deepening concern the nation won’t be able to fix its deteriorating finances.

Frankfurt-Trust Investment GmbH, Smith & Williamson Investment Management and Pictet Asset Management, which manage a combined $100 billion, say they are not ready to buy even after the biggest tumble in two-year notes since 1998. Standard & Poor’s put the nation’s debt on watch for a downgrade two days ago, and Fitch Ratings followed yesterday by cutting Greece’s credit rating one level to BBB+ from A-.

S&P; said two days ago Greece’s debt burden may climb to 125 percent of gross domestic product in 2010, the largest among the 27 European Union nations, and stay at that level or higher in the “medium term.” Fitch cited “concerns over the medium-term outlook for public finances given the weak credibility of fiscal institutions and the policy framework.”

Downward Pressure on Latvia and Lithuania

According to Fitch, Baltic Ratings Remain Under ‘Downward Pressure’

Fitch Ratings said Latvia and Lithuania’s sovereign ratings remain under “downward pressure” as the Baltic states’ economic plight sends their deficit and debt levels higher.

Latvia’s BB+ rating, the highest non-investment grade, and Lithuania’s BBB rating, two levels above junk, are more at risk of a downgrade than Estonia’s BBB+ rating, Fitch said in a statement today.

The Baltic states are suffering the deepest economic contractions in the European Union after their debt-fueled property bubbles burst and their governments forced through tough austerity measures.

Can Euroland Survive?

The Levy Economics Institute of Bard College is asking Can Euroland Survive?

Social unrest across Europe is growing as Euroland’s economy collapses faster than theUnited States’, the result of falling exports and a weaker fiscal response. The controversial title of this brief is based on a belief that the nature of the euro itself limits Euroland’s fiscal policy space. The nations that have adopted the euro face “market-imposed” fiscal constraints on borrowing because they are not sovereign countries. Research Associate Stephanie A. Kelton and Senior Scholar L. RandallWray foresee a real danger that these nations will be unable to prevent an
accelerating slide toward depression that will threaten the existence of the European Union (EU).

Unlike the case where the U.S. federal government rescued New York State, however, the procedure to bail out a member state is unknown. The ECB is practically prohibited from taking over the debts of member states, and, although it is impossible to surmise what the ECB might do in a crisis, there is enough uncertainty to create the possibility of a (bank) run stemming from an individual member’s debt. And, as discussed, there is no central fiscal authority that has anything like the responsibility of the U.S. Treasury. Charles Goodhart (2006) summarizes the problem:

The federal institutions in the EU have neither the ability, nor the wish, to guarantee the deficits of the subsidiary state governments. The ECB is admonished not to support failing State governments, and there is no fiscal competence at the federal level either to make inter-regional transfers in response to asymmetric shocks or to support the ECB in meeting the burden of bailing out a failing State government. So the federal government in the EU neither can, nor wants to, carry out its part in the kind of implicit bargains observed in other federal systems.

Once markets begin to perceive a nation as a “weak” issuer, they can effectively shut down a nation’s ability to stabilize conditions within its borders. This is the fundamental weakness of the euro zone that we have warned about since its inception. This means that bonds issued by Greece, Portugal, Ireland, and Italy are perceived to be instruments with less liquidity than those issued by Germany, France, or Finland. Even though the government debt of all member states is homogenous in terms of denomination, bonds issued by the smaller countries “will not have the same liquidity as those of larger countries” (The Irish Times 2009).

On the one hand, we admire the willingness of the EU and Euroland to embrace its new members. On the other hand, we suspect that expansion has made the prospects for changing the structure of the union virtually impossible. Hence, there remains the possibility of a trend toward dissolution rather than greater unification.

The Levy Institute article is 20 pages long and well worth a read.

I do not agree with one recurrent theme in the article (complaints about individual states in the EU growth constrained because they cannot go deeper in debt). The problem is debt, not the inability to add more debt. However, the article does correctly touch upon some of the problems unique to the EU arrangement.

I doubt the EU dissolves, but it clearly is not the safe haven have many think it is. Loans made to the Baltic states are in trouble, Greece itself is in serious trouble, and Spain is in serious trouble as is Ireland.

Most in the United States are too U.S. centric, not understanding any of the economic problems or currency problems elsewhere. Currency and fiscal problems are everywhere one looks.

Dubai Warning

Many think the market reaction to the Dubai default was way overdone. I prefer to think of it as a huge warning shot.

Given the market’s reaction to Dubai, pray tell what happens if Greece, Lithuania, or Latvia default? Please see Dubai Defaults – Deflation In Action – Watched Pot Theory Revisited for more the “Watched Pot Theory” of currency problems.

What if there is a currency crisis of some sort in Japan?

Meanwhile, the problems in the U.S. are very well understood by nearly everyone, and the dollar is despised by traders.

US$ Daily Chart

click on chart for sharper image

Fundamentally and technically I see no reason the US dollar cannot and should not retrace half of the decline from the top near 90. If that happens, and I think it is highly likely, equity and commodity bulls will feel like they were hit by a ton of bricks.

Mike “Mish” Shedlock
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