By Ryan DeCaro, Associate Investment Strategist

November 3rd, 2011

Late last week in Greece, government leaders within the European Union crafted a plan to help resolve the financial problems that have hampered the Eurozone for more than three years. The measures are aimed at restoring confidence and addressing some of the key tensions currently affecting the financial markets. The breadth and scope of the measures appears to be quite deep at the surface, but strict adherence to the plan will be the deciding factor as to whether it succeeds or fails.

During the latest six day summit (the European Union’s 14th crisis summit over the past 21 months), the leaders of the European Union agreed to seven main points that they hope will effectively manage the crisis in Greece and the surrounding peripheral countries. The overriding purpose of this intervention was to bring back peace, stability, and prosperity to the European Union. The broad based initiatives focused on Greece, but also offered aid and fiscal restrictions to the European Union as a whole. The proposal’s impact on the Greek economy will be the most pronounced, as the agreement pushes tough austerity measures on the failing country. These measures include getting Greece’s debt to GDP ratio below 120% by 2020, a level that it has not seen since early 2008. Debt to GDP is currently running at more than 150%, meaning that they will have to find ways to cut out billions of dollars in debt or find ways to significantly boost GDP. Either task will be difficult for the entitlement laden country.

To help this process, investors have been asked to take a 50% haircut on their investment in Greek sovereign debt. This issue was one of the last to be resolved as investors were extremely resistant to such a great discount, but realized that a return of 50% of their capital was far greater than no return at all. The reduction in this debt burden to the Greek government will amount to $100 billion euro. As long as Greece is able to maintain GDP of about $230 billion euro (their current GDP level) they would have fulfilled the 120% debt to GDP ratio required by the plan. Unfortunately, GDP has been declining rapidly of late so it will be rather difficult to keep it at current levels. If GDP were to decline by 25% to $175 billion euro (not a far stretch considering the austerity measures already passed by the Greek government) then they would have to reduce their debt burden by an additional $40 billion euro.

The plan commends other countries like Italy, Spain, and Ireland for their austerity efforts to date, saying that they are all well on their way to fiscal stability. Interestingly, Italy has backed off their stance on a balanced budget and increasing the retirement age. Italy agreed to have a balanced budget by 2013 and to increase the retirement age to 67 by 2026. The former is great news as it helps Italy get it fiscal house in order, but the latter shows the continued malaise that many of these European countries seemingly operate under. Taking more than a decade to increase the retirement age by 3 years is yet another example of why the European Union does not fully understand the severity of their fiscal problems.  The plan also called for additional fiscal consolidation and structural reforms as needed moving forward. An update will be provided by the European Council as to the extent of these reforms in a report set to be finalized in March 2012. Trying to get to a balanced budget, something the plan is requiring all Member States to come up with the framework for by the end of 2012, became somewhat more difficult for countries like Italy and Greece as well as the European Union as a whole under this plan.

In an effort to restore confidence in the banking sector, the European Council set up several measures to ensure the solvency of the European banks.  It put an emphasis on ensuring that medium-term funding and capital quality are sufficient. If funding is deemed to be insufficient, the European Council has committed to providing guarantees on the bank’s liabilities in an effort to limit deleveraging actions.  The plan also calls for a 9% tier one capital ratio by June 2012 to create a buffer for these banks.  Banks will be forced to recognize bad debt during this recapitalization period, further increasing the difficulty of meeting the new requirements.  To help this process along, the European Council decided to open the European Financial Stability Facility (EFSF) to banks that may have difficulty meeting these requirements. This allows the weak banks in Europe to survive the recapitalization process with the help of the European Union. This part of the proposal is very reminiscent of the TARP program that the United States implemented in 2008.

It appears that the measures they are taking are from the United States playbook back in 2008 when we introduced Quantitative Easing I and TARP, both measures were aimed at helping take the bank's bad debt off their balance sheet (in Europe’s case banks and countries) and provide liquidity when it was needed the most. The efforts in the US have been successful to date, providing some level of hope that the monetary policies put in place at the Summit will alleviate some of the region’s economic problems.

None of these proposals will work though if there is not strong governance both internally and externally.  The Council understood that governance was vitally important and detailed ways in which the European Union could monitor the progress of its Member States. The plan includes bringing together the Heads of State in the Eurozone and the President of the Commission at least twice a year to define strategic objectives, discuss economic issues, and help increase convergence of the Member States policies. Adequate governance will require commonalities among all Member States economic policies. Increased transparency was also stressed at the meeting. Keeping non-Euro area countries abreast of the region’s progress will add credibility to the plan and potentially open up new areas of funding. The Council has promised to provide clear rules and mechanisms to improve communication and ensure consistency in their message. These measures are meant to reduce fear within the Euro area and abroad.

The problems in the European Union have been building up since it’s founding in 1993. The Member States have acted as independent countries with a common currency. Economic policies have varied greatly, with a number of countries offering substantial entitlement programs (Greece, Italy, and Spain) and others practicing fiscal restraint (Germany). There has been a lack of communication among the Member States regarding the region’s objectives and governance has never been a priority.

Until recently, the problems within the Union have been hidden fairly well. It was not until the middle of this decade that we started to see how bad the fiscal problems were in some of these countries. These problems came to a head in 2008 when the global economy faced serious financial distress. For more than three years, the Union has debated ways to fix its problems. There have been countless Summits designed to restructure the way the Union operates. To date, none of these proposals have been successful at fixing the area’s economic problems. The most recent Summit provided the most widespread proposals to fixing its problems that we have seen in the Union’s history. Strict adherence to these problems, coupled with strong governance and aid from the European Central Bank, could finally provide the stability and unity that the European Union so dearly needs. Anything short of that jeopardizes the future of the Union as an entity and the Euro as a currency.