By Jon Markman
SEATTLE (MarketWatch) -- Anyone visiting Europe nowadays needs to add a new term to their foreign-language phrase book -- and it has nothing to do with food, wine or landscapes. The expression is "austerity budget," and in plain English it means "planned recession."
This is going to be the summer of the Continent's discontent, as governments face up to the fact that they must slash spending and payrolls to realign their cash flow with the interest payments on their sovereign debt. They have all decided to stop ignoring credit agencies' warnings that staying on their current path of overspending will bring costly and embarrassing downgrades.
Spain said it will start with a $18 billion cut of civil service jobs and retirement benefits; Italy vowed to cut its 2011 budget by $15 billion by not replacing civil service retirees and slashing drug spending; and the United Kingdom announced massive plans to cut health care and IT spending, and civil service payrolls.
A U.K. official said the cuts would "send a shock wave" through government departments, with public services hit hardest. Major U.S.-based tech and drug stocks have been reeling on this news, as IBM (IBM 127.68, +3.78, +3.05%) and Bristol Myers Squibb (BMY 25.50, +0.86, +3.49%)have reportedly been told to expect a 20% cut in British government spending alone.
Loose threads
To help us understand exactly what's going on, and why debt loads that have been growing for years have suddenly become a market-melting issue, I turned this week to Satyajit Das, an independent credit analyst in Australia. Though his vantage point is half a world away, Das is frequently sought out as a consultant by central bankers, government officials and fund managers for his unconflicted insights and his unusually clear explanation of the dense pathways of debt and its derivatives.
I started by asking why the sovereign bond crisis reared up to spook investors last week despite the lack of any new news.
"It's never incremental news -- it's how old news sinks into the people with brains the size of caraway seeds who populate the financial markets," he said from his office in Sydney. "They always depend on selective information and process it in uneven ways. Even smart people tend to believe what they want to believe, and they right now they're using the idea that central banks and governments will miraculously prevail as a crutch. This is magical thinking. I have said from the beginning that governments won't have enough money to bail everyone out."
Das believes the central problem is that governments have already spent more than $1 trillion in taxpayer-generated and borrowed funds but are not getting as much bang for their buck as expected. If you strip out government spending and low interest rates, he notes, there's not a whole lot of activity going on. The government has tried to prime the pump, but the pump is still just dribbling.
He suggests we not be fooled by recent earnings reports or government stats, pointing to U.S. bank earnings as especially inaccurate. JP Morgan has a balance sheet of $1 trillion and can borrow at essentially zero, he notes. So if they just go out and buy 10-year bonds at 3% they should be able to earn $30 billion a year. Yet the bank announced a profit of $3.3 billion last quarter.
"What does that tell you? It says they are losing money on everything else," Das says. "Strip out the gifts, and it's big net loss." And at big industrial concerns like General Electric, he argues, revenue growth is anemic -- so earnings growth is solely stemming from cost-cutting and layoffs.
European flares
As for Europe, Das argues that Greece is irrelevant except as a mirror of the future for other countries. . "If Greece goes back to Spartan times, it doesn't matter -- it's just a side show," he said. "What matters is that Greece points to the fundamental problem that most government debt has been misused. When it's time to refinance, the debt has not created any productive assets that generate the cash flow necessary to pay it off. And every other country has the same problem."
He's right about that. Much of the borrowing in Spain, Italy and Ireland, not to mention the United States, was used to purchase unproductive assets like overpriced homes and consumer goods -- not factories or businesses that create cash flow. It's like all the money that was snapped out of thin air in borrowing and equity sales in the late '90s dot-com years that was used to buy advertising rather than to make things. When the security sales end, the boom ends.
Das has an especially harsh view of the European Union officials and central bankers, whose disunity of late has bordered on farce.
"I deal with central bankers all the time, and I find it astonishing that people hold them in high regard," he said. "They may be bright, but they have studied more and more about less and less. They have no idea of how the world really works -- none whatsoever. Their lives are spent flying first-class to luxury hotels for conferences where they deliver papers written by their staffs that have a few linear regressions in them. They deal with everything on a theoretical level, and have virtually no one on their teams with practical experience."
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