Tuesday, January 3, 2012

Why The European Debt Crisis Will Worsen in 2012

The debt crisis will worsen this year because European countries will spend more than they generate in receipts in 2012. Thus, the government debt that has to be funded will be larger by the end of 2012 than it is now. Even under an optimistic scenario, the projected government deficits in 2012 will be greater than the rate of growth in GDP. The so called solutions to the European debt crisis seem to do little more than reduce the imminent risk of a government default or widespread bank failures. Given that the government debt auctions next year will have to fund even larger amounts of debt than the auctions in 2012, the increasing weight of the supply of government debt requiring funding will make the debt problem even worse.

A solution to the government debt crisis can only be found if government receipts grow faster than expenditures. This is not going to happen it 2012, as illustrated by the chart below showing projected government deficits and change in GDP by country.

Projected Government Deficits and Changes In GDP
(Source - OECD)

All the counties listed in the chart above are projected to run deficits that are greater on a percentage basis than the expected growth in their economies. If a European recession does hit, the impact on government debt    will be even worse than shown in the above projections.

The austerity plans being proposed across the Euro zone are half measures that continue down the path of deficit spending in 2012. These austerity plans envision reaching balanced budget status via a multi year process. As examples, France is targeting having a balanced budget by 2016 and Italy by 2013.

There are two reasons to doubt that the proposed austerity plans will really lead to balanced budgets across the Euro zone by 2016 (and certainly not by 2013 in the case of Italy).

Overly Optimistic Revenue and Growth Projections if Europe is Headed Into a Recession
If the economies of Europe are headed into a recession, as is widely expected, then tax revenues will decrease and deficits will widen.

The Unpopularity of Austerity Measures May Lead to the Downfall of Governments That Support Them.
It seems unlikely that the voters in all the countries of the Euro zone will have the political will to support austerity measures beyond 2012. Support for balanced budgets is likely to wane over the course of this year and in at least a few Euro zone countries politicians may be elected that turn the spending spigot back on.


The Euro zone leaders succeeded in kicking the can down the road in 2011. It will be even more of a challenge for them to avoid a financial meltdown in 2012 with even more debt to fund.

At least on the first trading day of 2012, investors in U.S stocks seem to be ignoring the risk of contagion to the U.S. economy from European problems. However, it seems unlikely that the European debt crisis will stay out of the headlines for long.

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Which Is A Bigger Threat To U.S. Stock Market - Declining Earnings or a Shock From Europe or Iran?

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