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European Disunion
New York: March 02, 2009
By John Stephenson

The pink slips continue to fly as companies chop overhead and the U.S. economy reels from the worst economic calamity since the Great Depression. Nationalization of the country's banking system, at least temporarily, seems like a virtual certainty as Bank of America and Citigroup continue to circle the drain. Against this backdrop, you might be forgiven for thinking that America 's problems are intractable, but by European standards, America 's ills may be just a walk in the park.

Both within the European Union (EU), as well as within the bordering countries of Central and Eastern Europe , the economic problems are massive. Nowhere are the economic problems more pronounced than in the smaller neighboring countries of Central and Eastern Europe that lived well beyond their means for years. Growth for many of these countries was fueled by borrowing much as it was in the U.S. But borrowers in Central and Eastern Europe took advantage of record low interest rates and relatively stable exchange rates to super charge their growth by taking out loans denominated in euros and Swiss francs. But what once looked like a sure thing has turned sour in a hurry as plunging currencies at home have caused debt burdens to rise and defaults to soar.

The situation has become so dire, that the European Bank for Reconstruction and Development warns that bad debts in Europe will top 10 percent this year and could reach 20 percent by the time all is said and done. The countries of Central and Eastern Europe were once economic miracles with fast growth rates and high expectations of eventual integration into the European Union. But much of that growth has been fueled by a borrowing binge that tops $1.7 trillion from abroad — the majority being funded by Western European banks. Austria 's exposure to borrowing from Central and Eastern Europe is a staggering amount, equivalent to more than three-quarters of its gross domestic product (GDP). Swedish banks are the biggest lenders to Latvia and other small Baltic countries.

Latvia posted years of double-digit economic growth as reckless borrowing and lending for construction and consumer loans helped fuel this dramatic growth. Today, the nation of just 2.4 million people is on the verge of bankruptcy. Last week, Standard and Poor's, a rating agency, slashed the credit ratings of both Ukraine and Latvia to low junk status — effectively cutting them off from the global capital markets.

As the problems of Eastern and Central Europe continue to spiral out of control, the risk of a debt default grows — potentially exacerbating the problems of Europe 's financial institutions further. Last week, the U.K. government brought the Royal Bank of Scotland Group PLC to the brink of nationalization, as the company posted the largest loss in U.K. history. The prospect of further defaults has both the European Union and the International Monetary Fund (IMF) running scared and determined not to let the crisis in Central and Eastern Europe further aggravate the problems in Western Europe .

As the financial cracks begin to widen, the very real prospect exists that the IMF may be too poor to help stem the rising tide of economic woes swamping the globe. Last week, Romania 's central bank said that it may need IMF aid to stabilize its crumbling finances. Estimates vary widely, but the global recession may bankrupt as many as sixteen countries, a circumstance that would completely swamp the resources of the IMF. The world's lender of last resort would be incapable of bailing out all of these countries should such a calamity occur.

Further complicating matters within Europe is the broad range of economic circumstances within the European Union itself. Plunging economies and soaring debts may cause once high-flying economies such as Spain , Greece and Ireland to either default on their debts or pull out of the Monetary Union.

In Spain , the unemployment rate hit 14 per cent in January, 2009, an increase of 47 per cent from the prior year, and it might reach as high as 20 per cent by 2011. The government has even taken the drastic step of paying foreign workers residing in Spain not to compete for jobs that native Spaniards could fill. There are at least 800,000 unsold homes on the Spanish property market and the recession is the worst in fifty years. France 's economy has also shrunk more than at any time in the last three decades. In Britain , striking nuclear and coal-fired electricity plant workers held signs saying “Put British workers first.” In eastern and central Europe , the situation is even worse, as local banks relied heavily on a flood of foreign capital during the boom years in order to finance their rapid expansion. Now, with a full blown crisis underway, foreigners are yanking home their capital, causing the currencies of these countries to plunge and unemployment to soar. All across Europe , protests and strikes are growing as workers fight for the few remaining jobs.

The economic stresses between the individual member countries of the European Union may even threaten the very existence of the monetary union. A single national currency and central bank can respond to a crisis by slashing interest rates dramatically to stimulate growth or by devaluing the currency. Because of its widely divergent economies, however, the European Central Bank can only implement a one-size-fits-all monetary policy in times like this. Countries such as Spain , Greece and Ireland , where economic conditions are dire, will be tempted to bail out their domestic economies with government spending. But that could well throw them offside with the European Union's mandate of a maximum government deficit of 3 per cent of GDP. The union will likely hold, but as long as talk of dissolution persists, the euro will come under pressure.

The crisis facing Europe may be concentrated in a few countries, but with the interlocking nature of both the European Union and global finance, negative repercussions can quickly spread across the continent. Europe desperately needs to find a unified approach to deal with this crisis, but nationalist sentiments and politics have stood in the way. Until Europeans can come up with a unified response to the problems in their own backyard, a global economic recovery is not in the cards.

StephensonFiles is a division of Stephenson & Company Inc. an investment research and asset management firm which publishes research reports and commentary from time to time on securities and trends in the marketplace. The opinions and information contained herein are based upon sources which we believe to be reliable, but Stephenson & Company makes no representation as to their timeliness, accuracy or completeness. Mr. Stephenson writes a regular commentary on the markets and individual securities and the opinions expressed in this commentary are his own. This report is not an offer to sell or a solicitation of an offer to buy any security. Nothing in this article constitutes individual investment, legal or tax advice. Investments involve risk and an investor may incur profits and losses. We, our affiliates, and any officer, director or stockholder or any member of their families may have a position in and may from time to time purchase or sell any securities discussed in our articles. At the time of writing this article, Mr. Stephenson may or may not have had an investment position in the securities mentioned in this article
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