European Crisis and the Difficulty in Learning From Past Mistakes

As predicted by Reinhart and Rogoff’s sequencing of the crisis, default on sovereign external and/or domestic debt is unfolding as expected. Despite this, EU political constituencies continue to be unable to formulate a viable rescue plan for Greece even with contagion to other weak countries already evident. As an aside, this lack of reaction is not dissimilar to initial the US Congressional rejection of the sub-prime bailout package not that long ago – in Sep 2008. Market reaction to each event is thus far similar: cautious optimism (about a viable solution) - increasing skepticism - disbelief - loss of confidence – mass sell-off. The market’s own five stages of dealing with tragedy.

Historically, the PIGS have had a poor experience following default or restructuring of external public debt. Amongst the four, Spain and Greece stand out in particular, with the latter having spent most of the 20th century mired in difficult times. According to Reinhart and Rogoff’s analysis, in comparison to all countries, Greece is bested only by Angola, Ecuador and Honduras.

Country	Period covered (external public debt)	Share of years in default or rescheduling	Number of years in default or rescheduling	Number of banking crises
Greece	1920 – 1983	50.6	31.9	2
Spain	1850 - 2006	23.7	37.0	8
Portugal	1851 – 1997	10.6	15.5	5
Italy	1880 – 2007	3.4	4.3	11

Source: Reinhart and Rogoff

A global financial crisis has been the lead-in to the current situation. Already weak economic conditions and metrics in their domestic markets are severely limiting their options. With their existing public debt levels already at high levels, increasing it further by only the average 86% based on past crises is unpalatable. Individual country options are limited due to the single currency and lack of political unity. And, as this crisis extends even further into personal balance sheets, unavailability of the personal bankruptcy option, particularly with respect to mortgage debt, will be another exacerbating feature.

From a financial sector stock selection perspective, during the sub-prime crisis, non-bank financials provided relative out-performance during 2008 and early 2009. A strong balance sheet and capital position were key. This time around, European non-bank financials do not look anywhere near as resilient.

Apparently, clear evidence from Reinhart and Rogoff’s rigorous analysis of eight centuries of financial folly has left political representatives unconvinced. We appear to be having difficulty learning from past mistakes. Here we go again.

Disclosure: Long C