Europe’s Greatest Cover-Up Could Mean the Death of the Euro

Harry_headshot-150x150It’s kind of like selling goods to consumers with very bad credit and then being surprised when they don’t pay.

But before I get into that, we all know Greece owes Germany, the ECB, and the IMF a lot of money.

Last week I explained that if they went the “Grexit” route, 75% of Greece’s government debt would’ve been wiped clean. That’s $90 billion to Germany alone and about $250 billion to the rest of the euro zone. It would have hurt, but there’s no avoiding pain at this point, and now it’s only going to be worse.

But there is another level of debt almost no one is talking about.

In fact, we have a harder time getting good information on it because the EU has increasingly hidden it.

However, this debt gets at the heart of why Germany and some of the strongest opponents to a Grexit were so desperate to keep Greece in the euro zone.

This not-much-talked-about debt are the TARGET2 loans Greece (and other euro zone importers) owes the rest of them.

It’s a fancy way of saying “past due accounts receivables.” Another way of saying this: “The check’s in the mail.” Or: “We’ll pay you when we can.”

Fat chance.

The idea is that when German or other euro zone companies sell goods to Greek companies, the Greek companies hand off their payment obligations to the Greece central bank. That central bank then owes Germany’s central bank, which then pays the German companies who sold the goods in the first place.

The problem is that the southern European countries – PIIGS, or Portugal, Italy, Greece, and Spain plus Ireland – import a ton. When Germany sells to Greece, Greece’s central banks collects the money, but doesn’t pay the German central banks. These are called TARGET2 loans.

They’re not really “loans” in the sense that they are involuntary. The German central bank knows that if it pushes too hard for these payments on time, exports will slow or discontinue without such credit extension. It’s either extend credit to these subprime borrowers or lose the sales!

It’s such a huge issue because these economically weaker nations aren’t competitive exporters. They can’t afford these outrageous trade deficits they’re wracking up! They have run increasing trade deficits ever since the euro was created. The currency lets them borrow at a cheaper rate. And the stronger exporting countries are willing to extend credit to keep their gravy train going.

Under this backwards arrangement, Greece owes Germany 100 billion euros, or roughly $109 billion. The broader euro zone – almost totally the PIIGS – owes it 531 billion. That’s almost $580 billion.

This is the most contentious example, but the Netherlands, Luxembourg and Finland are extending credit to these weaker central banks too – though nowhere near the extent of Germany, which holds around 75% of these TARGET2 loans.

The following chart shows the TARGET2 balances across the euro zone. Blue is the extended credit from the four major net exporters. Red is what the five net importers owe them.

TARGET 2 Balances Exporters and Importers

Before I even get into this, just take the chart at face value. Look at all that credit. It’s disgusting. We didn’t have this kind of foolishness prior to 2008. Now we live in an age where credit is king. Real value is supposed to be king. Cash is supposed to be king. Not credit. This nonsense has got to stop.

The edge of this graph shows the current balance for all TARGET2 loans: 709 billion euros ($774 billion). It actually peaked at 1.06 TRILLION euros in late 2012. Come on!

This gets at why Germany wasn’t in a hurry to let Greece leave the euro zone. And in fact, why it finally insisted they stay.

In government debt, Greece owes Germany 90 billion euros.

If Greece had exited, Germany would have had to write-off that amount overtime. The short-term affects for Germany would have been manageable.

But in addition to the government debt, Greece owes Germany another 100 billion in TARGET 2 loans. That would’ve been written off immediately. That’s much more painful and embarrassing to voters near term – which is the realm politicians live in.

That means Germany could see 190 billion euros – or $200 billion – in default if Greece exited. That’s much more than any other country by far.

To put this in more perspective, Germany’s GDP is about 2.9 trillion euros. 46% of that, or 1.3 trillion euros, is from exports. About 63% of that, or around 840 billion, goes to the euro zone. Exports are paramount to its aging economy that would otherwise already be slowing dramatically longer term!

That means the 531 billion in TARGET2 balances from the euro zone equals 63% of its exports, which means the payments are eight months late.

Any accountant worth his salt would lose his mind if account receivables were just three months late!

This is one of Europe’s dirtiest secrets.

To keep exports going to countries that can’t afford it, the central banks of the exporting nations have to extend high credit to the central banks of the weaker importing nations.

That way the stronger countries import more than they frankly should and the weaker nations live well beyond their means. This is the very imbalance that the euro has created since its inception in 1999.

Talk about denial.

Talk about not addressing the underlying problem.

Talk about kicking the can down the road!

This system won’t last. The euro won’t last. Watch out below in the months and years ahead when it finally cracks, or at best is restructured into a strong and weak version of the currency.

As bad as things will get in the U.S., there’s one bright spot: Thank god we’re not Europe. We will still be the best house in a very bad neighborhood ahead.

Harry

Follow me on Twitter @harrydentjr

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About Author

Harry studied economics in college in the ’70s, but found it vague and inconclusive. He became so disillusioned by the state of the profession that he turned his back on it. Instead, he threw himself into the burgeoning New Science of Finance, which married economic research and market research and encompassed identifying and studying demographic trends, business cycles, consumers’ purchasing power and many, many other trends that empowered him to forecast economic and market changes.