Bail Out Band Aid, Europe is Still Bleeding

The last thing you give a junky is another hit. At least that’s what doubters of Europe’s staggering rescue package for Greece are saying. Today’s market declines and record high gold prices reflect the sentiment.

There is an understanding that while the 1.1 trillion USD plan surpassed expectations, it is still only a safety net; a reassuring agreement designed to bust up speculators and negative feedback loops. At the end of the day, lending to already over-borrowed ‘Club Med’ economies doesn’t get to the fundamentals of Europe’s problem.

The EU solution reached Sunday night was just the easy part. Agreeing to back members in a default may be a political solution to abstract financial pressures like short sellers, speculators and bond traders.

If you’re unfamiliar with negative feedback loops and the kind of situation Sunday’s package was designed to stop, here it is in very simplified form: During the recession, analysts began to view Greece as a more risky borrower because of its high debt levels and stagnant economy. Interest rates were subsequently raised. Because countries often pay existing debt off with new debt, it became increasingly expensive for Athens to service its obligations. With little cash flow, Greece suddenly looked like an even riskier investment for lenders then it did before, and interest rates went up again. Repeat the self-enforcing cycle a few times; compound it with short selling sharks pushing for disaster and nervous, herd like institutional funds, and you’ve got the sovereign version of Bear Stearns. However, if creditors know that a stable body like the EU is backing their assets (which it now is), runs are much less likely.

But again, that doesn’t solve Europe’s real problem and as a result, the Euro and its indexes are down while gold continues to soar. Many of the union’s members have used monetary unity to borrow more than they could ever hope to pay back. They’ve been able to get away with it because Euro Zone regulators have lacked in monitoring the fiscal sloppiness of its members. Sunday was a big, much needed band-aid, but stocks won’t really recover until the underlying wound is fixed.

It does look like reform is on the way, and that Europe is eventually going to come out of all this for the better; with a much more efficient and disciplined fiscal policy and protection from this ever happening again. A firm hand will be needed though. Forcing Greece to cut its deficit from 14% of GDP to 3% while simultaneously fostering a lean and productive economy will be the union’s first step. If it succeeds, look for faith in Europe to be restored. Until