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THE “IMPOSSIBLE MATH” BEHIND THE EURO CRISIS

John Hussman’s weekly letter laid out, in simple terms, why the situation in Greece is dire – the math just doesn’t work.  He writes:

“As my friend John Mauldin wrote last week, “No country save Britain at the height of its empire has ever recovered from a debt-to-GDP ratio of over 150% without a default. None. And the reason is simple arithmetic. Even a nominal interest rate of 6% means that it takes 10% of your national income just to pay the interest. Not 10% of tax revenues, mind you; 10% of your total domestic production.”

For most countries in Europe, government revenues typically run between near 40% of GDP, while government spending presently runs several percent ahead of that. In Greece, government debt now represents about 150% of GDP at interest rates between about 10% for very short and very long-maturity debt, to about 25% annually on 2-year debt (reflecting a high expectation of default). The overall average yield on Greek debt is close to 15%. The problem is that 15% interest on 150% of GDP works out to 22.5% of GDP in interest costs if the debt actually has to be rolled-over without restructuring it. That would be more than half of the government revenues of Greece. The only way Greece can avoid default with that math is if investors quickly become willing to roll over the existing debt at an interest rate in the low single-digits.

While last week’s extension of further bailout provisions for Greece certainly gave the markets a rousing “risk on” day on Thursday, the main effect on Greek debt was to extend the expected date of certain default (estimated based on interest rate spreads and credit default swaps) from about 1.5 years away, where the expectation was on Wednesday, to closer to 2 years away, which is where the expectation was by Friday.

Unlike countries with an independent monetary policy, Greece can’t print its own currency, and can’t devalue its obligations on the foreign exchange markets. So it is stuck with impossible math, save for the willingness of other European countries – mainly France and Germany – to pay the tab. It’s still possible for Europe as a whole to summon the political will to do that, given that the GDP of Greece is only about 10% that of Germany. Still, Italy has a debt-to-GDP ratio of about 120%, and a GDP about two-thirds that of Germany, so the math becomes fairly daunting if contagion spreads past small countries such as Ireland and Portugal (which also have debt-to-GDP ratios near 100%).”

Europe is going to have to be more creative than this if they want to avoid a Greek default.

Source: Hussman Funds

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