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PIIGS update; the problem of public sector obesity

Judging from the rising yields on 2-yr Greek debt, Greece is very likely to default, and the likelihood of a significant default has only been rising in recent weeks. The prospect of a Greek default (which at this point would likely be equivalent to a "haircut" of 20-30% on its outstanding $500 billion of debt) has resulted in considerable angst in the financial markets, primarily because of the fear that if one of the PIIGS defaults, then others might too, and at some point (especially if Italy, with over $2 trillion of debt, were to default) the losses might overwhelm the eurozone banks, which own an awful lot of the stuff.

The above chart shows the Euro Stoxx Banks index, which rather dramatically illustrates these fears: the market value of Eurozone banks has fallen 78% from the 2007 highs; current values are down 45% from their 2011 highs; and current values are only 26% above their March 2009 lows. According to Zero Hedge, the decline in the market cap of the Euro banks from their 2007 highs now exceeds $1 trillion. Bad debts, in other words, have already wiped out one trillion dollars worth of Eurozone bank capital, and there's only $440 billion left.

The escalating losses being inflicted on Eurozone banks have likely sent over a half trillion dollars fleeing to the US banking system, as I discussed in a recent post. Such is the demand for US safe havens that the yield on 3-mo. T-bills has been approaching zero for the past two months (see chart above).

There is still reason to avoid outright panic, fortunately. As the top chart also shows, yields on non-Greek PIIGs debt have declined meaningfully in recent weeks. Whether this is due to ECB purchases of PIIGS debt, or to the conservative shift in the political winds in Europe is hard to say. But it becomes clearer every day that the underlying source of most of the world's problems these days is an obese public sector: too big, too inefficient, too intrusive, too burdensome, too regulating, too indebted, and too unionized. If the disease can be properly diagnosed, then there is reason to hope for a cure. But please, hold off on the tax hikes. We need to starve the beast, not feed it more.

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