Alice laughed. "There's no use trying," she said" One can't believe impossible things."

"I daresay you haven't had much practice," said the Queen. "When I was your age, I always did it for half-an-hour a day. Why, sometimes I've believed as many as six impossible things before breakfast."

- From Through the Looking Glass by Lewis Carroll

Economists and policy makers seem to want to believe impossible things in regards to the current debt crisis percolating throughout the world. And believing in them, they are adopting policies that will result in, well, tragedy. Today we address what passes for wisdom among the political crowd and see where we are headed, especially in Europe.

European leaders keep telling us that the break-up of the eurozone is inconceivable. I do not think they know what that word really means. Let's see if I can explain the problem so that even a politician can understand.

Six Impossible Things

I have written several letters over the years about the basic economic equation

GDP = C + I + G + (Net Exports)

Which is to say, that Gross Domestic Product in a country is equal to total Consumption (personal and business) plus Investments plus Government Spending plus next exports. This equation is known as an identity equation. It is true for all countries and times.

Now, gentle reader, I am going to spare you a few pages of algebra and cut to the chase. Let's divide a country's economy into three sections, private, government and exports. If you play with the variables a little bit you find that you get the following equation.

Domestic Private Sector Financial Balance + Governmental Fiscal Balance - the Current Account Balance (or Trade Deficit/Surplus) = 0

This equation was introduced to you a few months ago in an Outside the Box written by Rob Parenteau. We are going to review this briefly, as it is VERY important. Paragraphs in quotes will be from that letter. As Rob noted, "...keep in mind this is an accounting identity, not a theory. If it is wrong, then five centuries of double entry book keeping must also be wrong."

By Domestic Private Sector Financial Balance we mean the net balance of business and consumers. Are they borrowing money or paying down debt? Government Fiscal Balance is the same: is the government borrowing or paying down debt?  And the Current Account Balance is the trade deficit or surplus.

The implications are simple. The three items have to add up to zero. That means you cannot have  both surpluses in the private and government sectors and run a trade deficit. You have to have a trade surplus.

Let's make this simple. Let's say that the private sector runs a $100 surplus (they pay down debt) as does the government. Now, we subtract the trade balance. To make the equation come to zero it means that there must be a $200 trade surplus.

$100 (private debt reduction) + $100 (government debt reduction) - $200 (trade surplus) = 0.

But what if the country wanted to run a $100 trade deficit? Then that means that either private or public debt would have to increase by $100. The numbers have to add up to zero. One way for that to happen would be:

$50 (private debt reduction) + (-$150) (government deficit) - (-$100) (trade deficit) = 0. Remember that we are adding a negative number and subtracting a negative number.

Bottom line. You can run a trade deficit, reduce government debt and reduce private debt but not all three at the same time. Choose two. Choose carefully. And before we get into the implications, let's look at yet another equation, although this is somewhat simpler.

Delta Force

There are two and only two, ways that you can grow your economy. You can either increase your population or increase your productivity. That's it.

The Greek letter "Delta" is the symbol for change. So if you want to change your GDP you write that as:

? GDP = ? Population + ? Productivity

If you are a country facing a population decline (like Japan) that means to keep your GDP growing you have to increase your productivity even more. That is why I have written so much about demographics over the years. Population growth (or the lack thereof) is very important. Russia is facing a very serious problem over the next 20 years that will require either a significant increase in productivity or large immigration to stave off a collapsing economy. Russia's population has declined by almost 7 million in the last 19 years to 142 million. UN estimates are that it may shrink by about a third in the next 40 years. But that's another story for another letter.

One last economic insight. You cannot grow your debt faster than nominal GDP forever. At some point, the market begins to think you will not be able to pay your debts back. This is no different than the fact that a family cannot grow its debt faster than its income ability to pay the debt back. At some point, you run out of the ability to borrow more money as lenders "just say no."

As a family's or country's debts grow, the carrying cost or interest expenses rise. At some point, the interest expense consumes an   ever larger portion of the budget. Increasing the debt increases the interest expense eventually to the breaking point. There are limits.

Reduce your Deficits!

Now, let's look at the implication of all this. Let's start with Great Britain. They are running very large deficits on the order of 11% of GDP. Clearly, that is unsustainable and the new government knows it. They are looking to cut £6 billion in their first effort, which sounds like a lot, but is less than 4% of the £156 billion deficit. There is a lot more cutting that needs to be done.

But spending cuts and tax hikes have consequences. The UK retail industry is warning that a feared hike in value-added tax to 20% from the Conservative-Liberal Democrat government would cost 163,000 jobs and cut consumer spending by £3.6bn over four years. And that tax hike is just for openers.

The classic hope for any country in such a dire strait is to be able to grow your way out of the problem. Martin Wolfe wrote in the Financial Times a few weeks ago that Britain needed to let the pound drift lower so that British exports would be more competitive. A cheap pound will drive up tourism. Their trade deficit can become a trade surplus.

Here is their dilemma. In order to reduce the government's fiscal deficit, either private business must increase their deficits or the trade balance has to shift, or some combination. Lucky for them, they can in fact allow the pound to drift lower by monetizing some of their debt. Lucky, in they can at least find a path out or their morass. Of course, that means that pound denominated assets drop by another third against the dollar. It means that the buying power of British citizens for foreign goods is crushed. British citizens on pensions in foreign countries could see their locally denominated incomes drop by half from their peak (well, not against the euro which is also in free fall).

What's the alternative? Keep running those massive deficits until ever increasing borrowing costs blow a hole in your economy reducing your currency valuation anyway. And remember, if you reduce government spending, in the short run that is a drag on the economy, so you are guaranteeing slower growth in the short run. As I have been pointing out for a long time, countries around the world are down to no good choices.

Britain's is a much slower economy (maybe another recession), much lower buying power for the pound, lower real incomes for its workers, yet they have a path that they can get back on track in a few years. Because they have control of their currency and their debt which is mostly in their own currency, they can devalue their way to a solution.

Pity the Greeks

Some of my fondest memories were made in Greece. I like the country and the people. But they have made some bad choices and now must deal with the consequences.

We all know that Greek government deficits are somewhere around 14%. But their trade deficit is running north of 10%. (By comparison, the US trade deficit is now about 4%.)

Going back to the equation, if Greece wants to reduce its fiscal deficit by 11% over the next three years, then either private debt must increase or the trade deficit must drop sharply. That's the accounting rules.

But here's the problem. Greece cannot devalue its currency. It is (for now) stuck with the euro. So, how can they make their products more competitive? How do they grow their way out of their problems? How do they become more productive relative to the rest of Europe and the world?

Barring some new productivity boost in olive oil and produce production, there is no easy way. Since the beginning of the euro, Germany has become some 30% more productive than Greece. Very roughly, that means it cost 30% more to produce the same amount of goods. That is why Greece imports $64 billion and exports $21 billion.

What needs to happen for Greece to become more competitive? Labor costs must fall by a lot. And not by just 10 or 15%. But if labor costs drop (deflation) then that means that taxes also drop. The government takes in less and GDP drops. The perverse situation is that the debt to GDP ratio gets worse even as they enact their austerity measures.

In short, Greek life styles are on the line. They are going to fall. They have no choice. They are going to willingly have to put themselves into a severe recession or more realistically a depression.

Just as British incomes relative to their competitors will fall, Greek labor costs must fall as well. But the problem for Greeks is that the costs they bear are still in euros.

It becomes a most vicious spiral. The more cuts they make, the less income there is to tax, which means less government revenue which means more cuts which mean, etc.

And the solution is to borrow more money they cannot at the end of the day hope to pay. All that is happening is that the day of reckoning is delayed in the hope for some miracle.

What are their choices? They can simply default on the debt. Stop making any payments. That means they cannot borrow any money, but it would go along way toward balancing the government budget. Government employees would need to take large pay cuts and there would be other large cuts in services. It would be a depression, but you work your way out of it. You are still in the euro and need to figure out how to become more competitive.

Or, you could take the austerity, downsize your labor costs and borrow more money which means even larger debt service in a few years. Private citizens can go into more debt. (Remember, we have to have our balance!) This is also a depression.

Finally, you could leave the euro and devalue like Britain is going to do. Very ugly scenario, as contracts are in euros. The legal bills would go forever.

There are no good choices for the Greeks. No easy way. And then you wonder why people worry about contagion to Portugal and Spain?

I see that hand asking a question. Since the euro is falling won't that make Greece more competitive? The answer is yes and no. Yes, relative to the dollar and a lot of emerging market currencies. No to the rest of Europe, which are their main trade partners. A falling euro just makes economic export power Germany and the other northern countries even more competitive.

Europe as a whole has a small trade surplus. But the bulk of it comes from a few countries. For Greece to reduce their trade deficit is a very large life style change.

Germany is basically saying you should be like us. And everyone wants to be. Just not everyone can.

Every country cannot run a trade surplus. Someone has to buy. But the prescription that politicians want is for fiscal austerity and trade surpluses, at least for European countries. But if the PIIGS reduce their trade deficits, that will not be good for Germany.

Yet politicians want to believe that somehow we all can run surpluses, at least in their country. We can balance the budgets. We can reduce our debts. We all want to believe in that mythical Lake Woebegone, where all the kids are above average. Sadly, it just isn't possible for everyone to have a happy ending.

And this brings us to a last quick point, which some day will be its own letter. Every country wants it currency to be valued "fairly" which means lower than its competitors. With both Europe and Britain on their way to parity with the US dollar, what will be the reaction of Asia and especially China?

As Ollie said to Stan (Laurel and Hardy), "Here's another nice mess you've gotten me into!"  A nice mess indeed.

Should the US Bail Out European Banks?

The obvious answer to the above question, at least on this side of the Atlantic, is no. But that is the plan being foisted on US tax-payers by the International Monetary Fund. The IMF wants to create a $250 billion dollar bailout fund for Greece, Portugal, et al that the US will contribute roughly 20% to. This fund will loan money and that IMG debt will be subordinate (junior!) to regular Greek debt, so when Greece does default, and they will, the IMF is the last in line to get paid.

Where will the money go? It will buy mostly Greek rollover debt from European banks getting out of their Greek debt. It is a back door bailout for German and French banks. The US Senate voted 94-0 that the US should not fund any such debt if the Treasury cannot certify the probability of getting repayment. If the Obama administration allows this funding to go through, the hue and cry will be large. It is bad enough that we have to pay for Freddie and Fannie (already $400 billion and counting!). Not meaning to be churlish, but the French and Germans can bail out their own banks.

John Mauldin
John@FrontLineThoughts.com