Taking Risks and Reaping Rewards

Would you lend money to Portugal?

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Portugal's ability to borrow money stopped yesterday. They tried to sell bonds to raise money to pay its bills. There weren't enough buyers and they canceled the sale.

(I wonder if they actually cut up the national credit card in front of the heads of state or if they just take it away and give them the look of shame?)

This is bad, very bad.

Here's why:

Countries borrow money.

We know that the U.S. borrows money. We see it in the news all the time as national debt and the yearly deficit adding to that debt make top headlines.

And most people understand that there will be a point when all this debt comes due and those that have loaned the money will want the borrowers to pay it back. So how much is borrowed and how easily it can be paid back is important in determining if investors are willing to loan you money.

While continual borrowing hasn't been a problem for the US yet, it is a problem in many other countries right now. Portugal, Italy, Ireland, Greece, and Spain (PIIGS) have put themselves in to a situation where they need to borrow money to pay their bills, but fewer and fewer people are willing to lend to them.

Other countries like former Soviet Union nations share similar circumstances.

Lenders lend based on several factors not least of which is the ability to repay the loan. Repayment risk in the aforementioned countries is rising, and therefore so are interest rates. At some point, the risk isn't worth any reward and all the lenders simply stop lending.

This is what happed in Portugal.

The result of not being able to borrow to pay your bills is that you go bankrupt. While Portugal isn't quite there yet, clearly having a failed attempt at borrowing is a sign they are close.

Countries have gone bankrupt before and will continue to do so in the future. While never a good thing, if the country is small and somewhat isolated, like Zimbabwe, the impact on everyone else is small.

However, if the country isn't isolated, for example part of the European Union (EU), then the damage can spread, potentially like wild fire.

Another major issue with the EU is the separation of monetary and fiscal policy. When a nation joins the EU they give away the monetary function of that nation to the overall EU. They lose a bit of their sovereignty.

Now, just when they need to have control over their monetary policy, they are forced to go to outside organization that doesn't have only the interests of one nation at heart.

For Americans that would be like allowing the Federal Reserve functions to be carried out by someone other than Americans with the goal of doing what's best for everyone even at the expense of Americans. Americans wouldn't think of giving up that control.

The obvious solution is to raise taxes, cut spending, and painfully change the way the debtor nations operate. Equally obvious is the political turmoil that will cause and the strong desire of politicians to avoid it.

It's possible that many of the nations in trouble, if this continues to get worse, will want that control of monetary policy back and wonder why they gave it away in the first place. While it's still unlikely that the EU would break up, it's not beyond the realm of possibility.

Because someone better loan Portugal and several other nations some money, look for the European Central Bank (ECB), headed by Jean-Claude Trichet, to announce a plan to help. But the extent to which other nations are willing to help at the expense of their own fragile situation isn't clear.

Depending on what is proposed, this could calm the markets or stir controversy and pit nations against each other with the ECB in the middle. Regardless, much like our own bailouts, the fix isn't always a smooth transition to good times and uncertainty will linger.

Uncertainty increases risk and that hurts rewards and market prices fall. That's why few investors will lend money to Portugal and why this could be very, very bad.