Debt Still Matters

In October 1981 the collaboration of the rock band Queen and David Bowie released “Under Pressure”. The song evolved from a jam session the band had with Bowie into arguably the greatest rock anthem of the 1980s. The song begins simply with scat singing of “umm boom bah bay, umm bah boom bah bay“ then launches into a familiar refrain that topped billboards globally:

“Pressure, pushing down on me
Pressing down on you, no man asks for
Under pressure”

Under pressure may be understating the gravity of the European debt crisis German Chancellor Merkel , French President Sarkozy and European Central Bank President Draghi need to solve during the upcoming European Union Summit. Over the past several months we have witnessed dramatic leadership changes in Italy and Greece, continued pledges of austerity from other troubled European nations and an unprecedented coordinated effort of the Federal Reserve, ECB and other Central Banks to ensure liquidity in the event of a global financial crisis. Amidst all of these efforts one issue remains undeniable, unchanged and (comprehensively) unaddressed – the underlying high levels of debt that precipitated the current crisis. 

Let’s get back to basics; debt is created when one party provides funds to another party who has the contractual obligation to repay the first party. In its simplest form essentially this is how loans work. As anyone who has ever taken out a loan knows there are finite ways to remove the loan obligation- 1) pay it off, 2) work it off or 3) negotiate with the lender to change the terms/payment of the loan. That’s it.

Now consider the contractual obligations of the third largest Eurozone economy, Italy, which has a debt-to-GDP ratio of approximately 119%^[1]. The Italians would ideally like to decrease debt levels to a more manageable level but if we go back to the three basic ways to remove debt obligation, the Italian situation seems dire. First, to pay off debt in a sovereign context primarily comes from having a growing economy. Over the period January 2007 through September 2011 Italy has not seen any quarterly annualized GDP growth above 0.6%; furthermore over this period nearly 60% of the time Italy’s GDP experienced negative growth[2] . Secondly, in the contemporary vernacular of discussing the sovereign debt situation the idea of “working it off”, is equivalent to austerity. The newly elected Italian Prime Minister Mario Monti has proposed significant austerity in the form of higher taxes and more job cuts in an effort to save Italy but the reaction of the Italian populous was predictably rioting in the streets of Milan[3]. Beyond the very real problem of an unhappy citizenry, even with Prime Minister Monti’s €30 billion ($40.4 billion) austerity plan[4], moving from a lofty 119% debt-to-GDP to sub- 100% debt –to-GDP in a low/negative growth economic environment is near impossible without more austerity. Lastly, negotiating the terms of the debt is, at this point, a nonstarter as most of the debt holders are banks. We submit that if banks were to accept less than the full amount owed to them these institutions would have to write-down asset levels to amounts that would likely put greater pressure on the already beleaguered European banking system.   

“It's the terror of knowing
What this world is about
Watching some good friends
Screaming let me out
Pray tomorrow takes me higher
Pressure on people
People on streets”

While Italy is the current poster child for the sovereign debt debacle, let’s not forget that debt-to-GDP ratios for the likes of Greece (142.8%), Belgium (96.8%), Portugal (93.0%) and even Germany (83.2%) are well above the maximum 60% debt-to-GDP the 27 European Union members agreed to under the stability and growth pact enacted when the currency was first introduced in 1999[5].

Merkel, Sarkozy and Draghi now must deftly lead those 27 member states during the upcoming European Summit to directly address the current sovereign debt crisis. With the world watching and expectations rising they are significantly under pressure to deliver a solution. We suspect that any solution put forth will in all likelihood not be viable and/or comprehensive but rather a shiny veneer giving investors a false sense of security. That said, whatever the ultimate outcome of the European Summit, we continue to believe that the underlying fiscal problems need to be addressed before sustainable economic growth can occur because in the end – debt still matters.

“Chippin' around
Kick my brains 'round the floor
These are the days
It never rains but it pours

This is our last dance
This is ourselves under pressure
Under pressure”

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[1]CNN “European public debt at a glance”, July 21, 2011

[2]Trade Economics, http://www.trading economics.com/Italy/gdp-growth

[3]ABC News “Reforms spark riots in Italy, Greece”, updated November 18, 2011

[4]Bloomberg, “Treasuries Erase Drop After S&P Warns of European Credit Rating Reductions” Dec 5, 2011

[5]CNN “European public debt at a glance”, July 21, 2011