How to Solve the European Sovereign Debt Crisis

“It’s a question of courage or actually facing the issues, not being in denial, accepting the truth, accepting the reality and then dealing with it.” 

That is what is needed to resolve the European sovereign debt crisis.  So says Christine Lagarde, the managing director of the International Monetary Fund. (http://www.bloomberg.com/news/2011-12-15/imf-s-lagarde-says-escalating-european-crisis-requires-more-cooperation.html)

Need one say more?

But, she stated, the world economic outlook “is quite gloomy” with a pervasive downside risk.

So, the international community must work together. 

Working together means that, starting at the core…the European countries…economic and fiscal union must be achieved.  This would be attained through fiscal solidarity and risk-sharing around the globe. 

Unfortunately, one has to ask…is this “actually facing the issues…accepting the truth…accepting reality...” or is it just another way to postpone what needs to be done for a while longer?

My blog yesterday discussed the underlying economic dilemma faced by the European nations.  Over the past ten years or so, unit labor costs in Germany have increased 20 percent to 30 percent less than in other eurozone countries. (http://seekingalpha.com/article/313888-the-problem-is-germany)  That is, German labor has consistently become more productive than non-German labor.

And, the non-German countries, in an attempt to keep their labor as fully employed as possible given the divergence in labor productivity, engaged in programs of fiscal stimulus which created a credit inflation that was unsustainable.  Hence, the sovereign debt crisis.

Since the eurozone is subject to a single monetary authority and a common currency, fiscal budget tightening, at this time, can only bring on the “pain and suffering” of a recessionary restructuring.

The problem is that countries within the European Union have been allowed to get “out-of-line” with one another, economically.  And, in a union of countries like this, nations cannot “paper-over” the differences in labor productivity by the creation of lots and lots of debt.  In fact, such behavior only can exacerbate the problem.

The countries in the European Union are facing a need for a massive restructuring of their economies, their labor markets, and their industrial structure.  Yet, “fiscal solidarity and risk-sharing” will not do this job. 

As I mention in my blog post yesterday and Alan Blinder states in his op-ed piece in the Wall Street Journal (http://professional.wsj.com/article/SB10001424052970203430404577094313707190708.html?mod=ITP_opinion_0&mg=reno-secaucus-wsj) we have reached the stage where the only possible solution may be a substantial change in how people do things.

According to Blinder, the only path left may be debt deflation. The countries, other than Germany, “can experience deflation, meaning a prolonged decline in both wages and prices, which is incredibly difficult and painful—which generally happens only in protracted recessions.”

A possible response to this, however, is social unrest.  We have already seen protests in Greece, and Spain and Italy and France…  But, protests have become a worldwide phenomenon.  We have protests in Russia.  These movements are also seen as a kin to the events of the Arab spring.  Furthermore, there are the “Occupy” efforts…in the United States…and in other parts of the world that cannot be totally divorced from these other events.  Modern information technology is being felt everywhere.

It is difficult to see how the protests and unrest in the non-German countries of the eurozone are going to resolve the situation.  Just as with the idea of “fiscal solidarity and risk-sharing”, a movement that does not address the fundamental misallocations that exist within these societies will not come up with viable alternative solutions.   

The issue is that many countries are “out-of-line” economically.  German labor productivity exceeds that of other European nations.  The industrial structure of Germany is more competitive than the non-German eurozone countries in the global marketplace.

I am not in favor of returning to a world of mercantilism, as I mentioned in yesterday’s blog.  But, as many emerging nations have recently managed their economies so as to improve their relative position in the world, those developed countries that have focused just on buying off labor unrest over the past fifty years, may have to alter their approach to how their economies are managed.  “Soft” solutions will only enlarge the gap they face with more competitive nations.   

Remember, one conclusion about the internal management of a nation’s economy within the framework of world trade is that a country can only choose two of the following three alternatives available to them: the nation can have a fixed exchange rate; it can have a free flow of capital internationally; or it can conduct an economic policy independent of all other countries.  This problem is referred to as the “trilemma.”

Well, the countries within the eurozone have a fixed exchange rate and they have a free flow of capital internationally.  Therefore, they cannot conduct their economic policies independently of the rest of the world.

The only thing left for these countries to do is to create an environment in which the productivity of their labor and capital become more competitive within world markets.  If not, the most productive capital and labor will move on to other nations. 

This solution has little to do with “fiscal solidarity and risk-sharing.”

The labor and capital utilization within the countries that are not doing so well…must be restructured.

As managing director Christine Lagarde stated, “It’s a question of courage or actually facing the issues, not being in denial, accepting the truth, accepting the reality and then dealing with it.”

I’m not sure she is there yet…but neither are a lot of other people.  

Initial Verdict on European Summit: the Can Got Kicked Further Down the Road

“European leaders’ blueprint for a closer fiscal union to save their single currency left the onus on central bankers to address investor concerns that Italy and Spain would succumb to the two-year-old financial crisis.” (http://www.bloomberg.com/news/2011-12-09/euro-states-to-shift-267-billion-to-imf-as-focus-shifts-to-deficit-deal.html)

In other words, the so-called leaders of the European Union did not lead! 

In place of action, they asked the European Central Bank to cover for them.

 

“Nineteen months since euro leaders forged their first plan to contain the debt turmoil, the fifth comprehensive effort added 200 billion euros ($267 billion) to the war chest and tightened rules to curb future debts. They sped the start of a 500 billion-euro rescue fund to next year and diluted a demand that bondholders shoulder losses in rescues.”

The biggest winner: Nicholas Sarkozy.  The “second best” award went to Angela Merkel. 

In other words, we still have not resolved the European sovereign debt crisis. 

And, what else was occurred?

The major loser award was given to Britain’ David Cameron.  Cameron refused to agree to a full change in the treaty for all 27 members of the European Union if there were no special safeguards for the financial services of the United Kingdom…more specifically, protection for the financial industry in London.  In taking such a stance, Cameron basically isolated himself from the proceedings of the summit.

The response of Financial Times editorial writer Wolfgang Münchau: “So we have two crises now. A still-unresolved eurozone crises and a crisis of the European Union.” (http://blogs.ft.com/the-a-list/2011/12/09/the-only-way-to-save-the-eurozone-is-to-destroy-the-eu/#axzz1g2glnIN4)

To Münchau, “The eurozone may, or may not, break up. The EU almost certainly will. The decision by the eurozone countries to go outside the legal framework of the EU and to set up the core of a fiscal union in a multilateral treaty will eventually produce this split.”

In other words, the inability of the officials of Europe to resolve the sovereign debt crisis is leading to additional difficulties that must be dealt with going forward.

The problem with not dealing with problems is that the problems tend to multiply and grow.

And, what about the threat made by Standard & Poor’s?  Will Standard & Poor’s downgrade the debts of the eurozone countries? 

The initial feeling is one of uncertainty.  It may be that Standard & Poor’s will not move right away…but, the European sovereign debt crisis is not over and the downgrade will probably come in the very near future. 

But, this raises another question…what about the European banks who hold so much of the sovereign debt of these nations?

Yesterday, the European Banking Authority declared that European banks needed to add 115 billion in euros to their capital base by next June.  New stress tests have indicated that the banking system, especially Germany’s, has a much bigger shortfall of capital than earlier thought.  Without the capital the EBA is concerned that the banks will be able to handle the continued financial stress in European capital markets. 

European officials, once again, fail to get their arms around the situation.

Perhaps one should not be surprised at this.

However, one question still lingers in my mind.  So much was made of the role that Angela Merkel was playing in the effort to get a more comprehensive solution to the European problems that concerns were raised about the possibility of German dominance of the European Union.  I even saw articles that made the following assertion: “What Germany could not achieve by military might may be obtained through financial strength.” 

If this is true then it appears that Europe is still fighting the old battles.  As long as Europe continues to operate on the basis of prejudices established years ago it will not move itself into the 21^st century.  If this is true, the European financial crisis still has a long way to go.

What If Europe "Marked-to-Market"?

“The now inevitable restructuring of eurozone debt…”

So writes Jim Millstein, Chairman of Millstein & Co. and former chief restructuring officer of the US Treasury Department. (http://www.ft.com/intl/cms/s/0/461464fa-0617-11e1-a079-00144feabdc0.html#axzz1dmPTNMw5)

Have people really come to accept this fact?

The full sentence: reads “The now inevitable restructuring of eurozone debt will result in bank capital deficiencies that the IMF estimates could exceed €300 billion.”

Now, what if we added a European recession on top of this, a recession that would slow down government receipts and increase unemployment payments and so forth?

Just out this morning: “A rebound in German and French growth propelled a modest expansion of the eurozone economy in the third quarter of this year – but failed to dispel fears of a looming recession across the 17-country region.

Eurozone gross domestic product expanded 0.2 per cent compared with the previous three months – the same pace of expansion as in the second quarter, according to Eurostat, the European Union’s statistical office. But with the escalating debt crisis already feeding into falling factory production, growth may already have gone into reverse, economists warned.” (http://www.ft.com/intl/cms/s/0/d1b0e2c6-0f5f-11e1-88cc-00144feabdc0.html#axzz1dmPTNMw5)

Are we coming to the end game?

Angela Merkel, the German chancellor, is now calling for a political union of Europe as the only way to “underpin” the euro and help the members of Europe emerge from their “toughest hour since the second world war.”

Doom and gloom seem to be all around us.  Just in the past two days we have articles like “New Austerity Incites a Bitterness the Postwar Generation Did Without,” (http://www.nytimes.com/2011/11/14/world/europe/austerity-in-europe-brings-bitterness-unknown-in-postwar-era.html?_r=1&scp=2&sq=alan%20cowell&st=cse) and David Brook’s “Let’s All Feel Superior,” (http://www.nytimes.com/2011/11/15/opinion/brooks-lets-all-feel-superior.html?hp0).  Also, this morning there is a review of Niall Ferguson’s new book “Civilization” whose subject matter is “the end of western civilization as we know it”  (http://www.nytimes.com/2011/11/15/books/niall-fergusons-empire-traces-wests-decline-review.html?ref=books).

Do these pieces of information point to the existence of a debt deflation cycle that is at the opposite end of the spectrum from the credit inflation cycle that we have been going through for the past fifty years? (http://seekingalpha.com/article/307261-debt-deflation-is-it-a-possibility)

The solutions Mr. Millstein proposes for the writing down of European sovereign debt are focused on the banking system and the estimated bank capital deficiencies.  But, part of the solution involves more debt: “a federal financial body, such as the European Investment Bank, must provide a capital backstop…”  In other words, more debt!

But, “To give it the firepower it needs for the size of the problem, the EIB must be empowered to raise debt supported by a stream of new tax revenues dedicated to retire the debt incurred.”  And, “the EIB’s capital backstop should be funded through a new federal tax on bank salaries and profits above defined levels.”

This does not seem like a solution to me.  The solution to the problem of too much debt around is not more debt and more taxes.  Yet that seems to be the best that many people can come up with.  However, this seems to me to be more of the same “thinking” that got us into this situation.

This brings me back to the opening quote: “The now inevitable restructuring of eurozone debt…”

The European problem is not a new one; it has been growing for several years now.  Government officials have just not been willing to accept the reality of the situation and economists have helped them to hide their heads in the sand by arguing that Europe’s problem has been one of “liquidity” and not one of “solvency.” 

If the problem is one of “liquidity” then a bank…or, anybody else…does not have to mark down an asset because the bank will, they say, hold the asset until it matures.  If the bank accepted the fact that the asset was experiencing difficulties then it would have to “mark” the value of the asset down.  But, this admits that something might be wrong…and people don’t like to admit that a mistake might have been made.

And, as Steven Covey has stated, “if the problem is ‘out there’, that is the problem!”  Even a month ago, European officials were still claiming that their problem was one of “liquidity” brought on by speculators and other “greedy bastards.”  And, if the problem was someone else’s fault, real solutions could be postponed.  And that is what these officials did.

“Solvency” problems, however, do not just go away.  First, “solvency” problems have to be recognized…people have to “own” them before anything can be done about them. 

I am still not convinced that we have arrived at that point.  Yes, we have an editorial piece in the Financial Times that declares that “the inevitable restructuring of eurozone debt” must take place.  However, eurozone governments, I don’t believe, generally accept this conclusion. 

Until eurozone officials do accept the fact that “all” eurozone debt must be restructured, the problem will still be that these officials do not accept the fact that their debt must be restructured.  And, this is no solution.    

Merkozy Posts A Win!

Greek prime minister George Papandreou cancelled the referendum.  Angela Merkel and Nicolas Sarkozy called Papandreou back to the “shed” Wednesday for a tongue-lashing…and worse…to set him straight on the marching orders he had been given. 

And, the Greek prime minister backed down.

It seems as if Merkel and Sarkozy believe that there are only two choices in the current debate.  The first is that the European Union stay together and maintain the single currency zone.

The alternative is that the EU split up with some countries maintaining the single currency zone.

To Merkel and Sarkozy there really is no choice…the EU stays together and supports the euro.

If the EU stays together and supports the euro…then the bailouts will continue. 

It seems to me that there are two most likely outcomes to following this path.  Of course, there are more but they are all derivatives of these two in my mind.

First, financial markets will continue to reject the solution and there will be further “summits” down the road with more bailouts and more distress.  The ultimate result of following this path will be when the EU finally decides that the fiscal policies of all countries in the union will have to be coordinated and there will be fiscal and political union as well as monetary union.

Some have seen this conclusion as the missing component of the efforts to achieve the monetary union right from the start.  Others, like myself, have seen this possibility as the ultimate end to the financial crisis as we now know it.  And, a political union may have been the goal of some EU “leaders” throughout the turmoil. 

If there is going to be a real “coming together” of the nations in the EU, the “strong” will be the drivers (Germany and France and who else?) but in order to achieve the final union the solvency of the laggards (Greece, Italy, Spain, Portugal and who else?) will have to be resolved.  That is, there will have to be some kind of central “Treasury” that will aggregate all debts and pay off those nations still in the union that are insolvent.

One can look at the American after its Revolutionary War where Alexander Hamilton opted for a strong central “Treasury” and the assumption of all of the debts of the states that were then a part of the United States.

The problem with this solution?

The problem lies with the people of the nations within the EU.  Some of these people’s may not want to come under the regime of the “strong” nations that will be the driving force in a strong, centralized fiscal EU. 

There have been riots and protests in Greece…and in Spain…and in Portugal…and in Italy…indicating resistance to the fiscal austerity being imposed on them by especially Germany and France.

And, the resistance is even getting more personal.  For example, a Greek newspaper has a cartoon with a German general manipulating two puppets…the two puppet being the Greek prime minister and another Greek official.  The underlying theme: “The Germans didn’t succeed in occupying Greece through arms because the Greek people resisted.  They try now to occupy Greece through the economy.”

Pretty heavy stuff. 

The Merkel/Sarkozy path to fiscal/political union may be a desirable goal but the question that still needs to be asked is whether or not this goal is consistent with what the people in these countries want.  European officials have often been accused of being an “elite” that wishes to impose its will upon the people of Europe.  Whether or not the “elites” can pull off this union without too great of a popular upheaval is a question that no one can answer at this moment.

The other alternative is that the financial markets may not allow the “leaders” of Europe to get too much farther  along this path. 

Just today, 10-year Greek bonds were trading to yield almost 34 percent, almost 3,200 basis points above the yield on 10-Year German bonds.  The bonds of the Italian government have been trading at the largest spreads above the German bonds in the euro era.  And the same with the bonds of Portugal. 

If these governments have to pay these kinds of yields on their debt there is no way that they will be able to get their fiscal budgets under control.  If these governments cannot issue bonds or can only issue them to the European Central Bank then the fundamental reality of their insolvency will become more and more of a problem. 

Add to this a European recession, where tax revenues take a further nose-dive, and you only exacerbate the problem.

I should add that “Super Mario” Draghi, the new head of the ECB oversaw a reduction in the central bank’s main policy interest rate in his third day in the new job.  The reason for this reduction is to combat weaknesses being experienced in European economies.

Over-shadowing all of this is the fear of the European officials of financial “contagion”.  The spectre of Lehman Brothers hovers over Europe. The fear is that if these “officials” let Greece go “insolvent” in a “disorderly default” kicking off the use of Credit Default Swaps, that there will be a “spill over” effect moving from the sovereign debt of Italy…and of Spain…and of Portugal.  Then, the concern spreads to the commercial banks in Europe…remember the stress tests conducted on these banks did not include a write down of the sovereign debt on their balance sheets.

The problem Europe is facing is a solvency problem.  This is what European officials have been trying to deny for the last four years.  And, many are still in denial!

Solvency problems do not just go away!  Denying they exist only causes the problems to get worse!

Second European Market Response: Italian Borrowing Costs Surge

The first response of world financial markets to the eurozone package produced early Thursday morning was positive. 

The second response…

“Italy issued 10-year debt on Friday but paid the highest price since joining the euro as investors demonstrated skepticism over the center-right government’s economic reform program in the first bond auction in the region since new steps were agreed to tackle the eurozone debt crisis.

The auction served to underline Italy’s current dependence on purchases of its bonds on the open market by the European Central Bank in a program that began on August 8 as yields rose above 6 per cent.” (http://www.ft.com/intl/cms/s/0/c7d47b22-0146-11e1-ae24-00144feabdc0.html#axzz1c10EG1Ea)

The underlying concern with the new eurozone package is that the officials in Europe still believe that the problem is one of liquidity, a crisis in confidence, which can be resolved by more bailout gimmicks.  As a consequence, these officials have, once again, avoided the fact that the problems they are facing are solvency problems and that eventually someone will have to bear losses.  The solvency issue has not been resolved since little or no new money is being put on the table.

Yes, there is an agreement for a 50 percent write down of “private” holdings of Greek debt.  But, note, that “public” holdings of Greek debt amount to about 40 percent of the total Greek debt outstanding.  These “public” holdings will not be subject to the haircut reducing the debt. 

The “public” holdings include the Greek securities held by the European Central Bank, the International Monetary Fund, and eurozone governments. 

Furthermore, the “haircut” is a “voluntary” write down in the hopes that a payout on Credit Default Swaps will not be triggered.  European leaders feared that if a “non-voluntary” event occurred, a CDS payment would be kicked off and this might cause a “Lehman Brothers affect” which would create more funding problems for banking institutions throughout the continent.

Also, this funding problem might expose other countries…like Italy, Spain, Portugal and France…in their efforts to place their sovereign debt.

The difficulty Italy had in placing its debt on Friday might be an indication that this effect is already at work.

 And what additional pressure does this put on the European Central Bank?

“
The ECB remained firmly in crisis management mode following the marathon Brussels summit to stem the sovereign debt crisis.

Within hours of the meeting, traders reported that the ECB was intervening again in the Italian government bond market – a clear sign that its controversial purchases were far from being wound down. “ (http://www.ft.com/intl/cms/s/0/7d4850e6-00a7-11e1-ba33-00144feabdc0.html#axzz1c10EG1Ea)

Included in the plan was a proposal for the recapitalization of European banks.  But, the question is, will these new requirements actually provide the protection needed.  In the recent failure of the Dexia bank, the bank met the initial requirements for capital.  It seems as if the regulators of the European financial system are still reluctant to admit the serious needs of the banking system to add capital…a shortcoming that is related to the “joke” these regulators perpetrated in the two applications of “stress tests” to the banks of Europe. 


But, the European officials also included in their bank recapitalization plan a proposal that the national governments in Europe would increase guarantees of their banks.  This just increases the specter that these national governments will have additional liabilities adding to their already heavy debt loads. 

Finally, there is the European Financial Stability Facility (EFSF).  This is the last resort lender in which everyone in Europe commits to bailing out everyone else in Europe.  That is, the EFSF is a scheme that says that “Europe is Solvent”…even though individual nations within the eurozone are not solvent.

Whether or not “Europe is Solvent” depends on the willingness of the solvent countries within the EU to continue to pay for the shortcomings of those countries that are not solvent.  The success of this depends upon whether or not the existing problems are “liquidity” problems or “solvency” problems.  “Liquidity” problems relate to a lack of confidence and a lack of confidence can only be a short-term phenomenon. 

Officials hope that by “re-arranging the chairs” once again that the crisis of confidence will come to an end.  The thing these European officials fail to understand that in the game of “musical chairs”, every time the music begins to play again another chair is taken from the game.  At some point, the fact that the eurozone does not have sufficient capital to cover its outstanding debt will become evident.

The efforts to bring money in from China, Japan, or elsewhere, seem like a desperate move.   

Again, it seems as if Europe has come up short again. 

News From Italy: A Bargain is Struck?

The news out of Rome:

“Silvio Berlusconi has salvaged a compromise agreement on economic reforms with his coalition partners that commentators said lacks specifics and risks falling short of what eurozone leaders have demanded ahead of Wednesday’s summit in Brussels.” (http://www.ft.com/intl/cms/s/0/5945e250-ffba-11e0-89ce-00144feabdc0.html#axzz1bjQzVRpl)

The crucial point…the plan “lacks specifics and risks falling short”…

Prime minister Berlusconi and the head of his coalition partner, the Northern League, Umberto Bossi, negotiated the new compromise package to submit to other eurozone leaders.  Other than reaching some kind of agreement, the alternative is for Mr. Berlusconi to resign.

The prospects do not seem to be encouraging:

“Newspaper editorials on Wednesday said Mr. Berlusconi and Mr. Bossi may have staved off a collapse of their coalition for the time being, but at the risk of undermining a critical summit and failing to deliver the reforms Italy needs to lift an economy on the edge of a renewed recession.”

Mr. Bossi is not a fan of the European arrangement…a euro-skeptic.  Hence, his tradeoffs are substantially different from those of Berlusconi.  And, Mr. Berlusconi does not have much personal credibility…and little or no moral stature…to trade on.

In fact, Beppe Severginini in a Financial Post op-ed piece goes even further:

“How can the world’s eighth largest economy go on with a delusional prime minister, a weak government, an impotent opposition and its finances in disarray?” (http://www.ft.com/intl/cms/s/0/c78b1142-fe6e-11e0-bac4-00144feabdc0.html#axzz1bjQzVRpl)

How did someone like Berlusconi become prime minister in the first place?  Well, as one person commentated on my earlier post this week, Mr. Berlusconi became prime minister of Italy because everyone else running for the position was worse than he was.  Encouraging…

So where does that leave Europe?

Mr. Sarkozy and Ms. Merkel appeared to be applying the pressure to Mr. Berlusconi over the weekend.  This precipitated the efforts of the past two days. 

If the reports of the reform plan concocted by Berlusconi and his coalition are true and the plan really does fall short of what is necessary, the question becomes, will Sarkozy and Merkel “stick to their guns” and hold Italy’s “feet to the fire”?  Or, will the French and German officials back off and attempt to get by with something less than they stated was necessary. 

The crucial thing here, to me, is that the pressure on Italy was applied because several eurozone officials believed that the problems they faced were deep enough that an attempt needed to be made to “encircle” the major problems and not just work on individual nations on a case-by-case basis. (See my post “Italy is the Key to Solving the Euro Debt Crisis”, http://seekingalpha.com/article/301607-italy-is-the-key-to-solving-the-euro-debt-crisis.)  Whereas in the past, the European Union began with the smallest, weakest link in the chain and then moved up to the next, larger, crisis, the current move was to include the third largest economy in the EU along with the weakest, Greece, and this, then, would include all that was in-between, like Spain and Portugal. 

Now, this may not be achieved.  We wait to see how Mr. Sarkozy and Ms. Merkel respond to the new Italian proposal.

But, this is not all.  The banking situation in Europe still lingers. (http://seekingalpha.com/article/301369-europeans-facing-more-of-a-haircut-than-preciously-thought) European banks are balking over the proposed debt “haircuts” and the new proposed capital requirements. 

It would seem that if Sarkozy and Merkel “back off” any on the Italy effort, given the pressure put on Italy over the weekend, that the banks will smell the weakness and put up even more resistance to the effort to write down the debt issues under consideration as far as needed. 

This, of course, puts the eurozone in a more tenuous position because lack of cooperation by the banks on the write-downs has implications that relate to a “triggering event” which might set off “bankruptcy” questions leading to payoffs on Credit Default Swaps.  The possibility of this occurring raises the specter of contagion in the financial sector, ala’ the Lehman Brothers affair, something eurozone officials sincerely want to avoid.

It seems as if European officials are running out of choices.  Yet, as we have seen in the past, European officials are masters of the art of squirming out of difficult spots and postponing solutions for another time. 

The betting still seems to be on the conclusion that no real leaders will arise in Europe to resolve the problems that Europe faces.  We can only hope for a better outcome

Can Berlusconi Pull It Off?

In my last post I wrote about the role that Italy might play in any solution to the European sovereign debt crisis. (See http://seekingalpha.com/article/301607-italy-is-the-key-to-solving-the-euro-debt-crisis.)

It seems as if the pressure applied on the Italian prime minister might be paying off.

“Silvio Berlusconi has called a cabinet meeting for Monday evening to consider new economic reform proposals after the prime minister returned to Italy following his humiliation at the eurozone leaders’ summit in Brussels.

The emergency meeting was called in response to demands by the summit that Italy prepare legislation on structural reforms before the next meeting of eurozone leaders on Wednesday.” (http://www.ft.com/intl/cms/s/0/ead92fb8-fe18-11e0-a1eb-00144feabdc0.html#axzz1bjQzVRpl)

Mr. Berlusconi, in the face of political pressure and financial market pressure, is going to propose some “tough” measures to his coalition cabinet.  But, his Northern League coalition allies are flat out against some of the things he has presented.  Others in the coalition are seen as too divided internally to “agree on tough reforms”.

Still, Mr. Berlusconi is giving it a try.  His embarrassment in front of European Union members has been substantial.  It appears that he is attempting to “save face” before the eurozone officials assemble again on Wednesday.  An alternative, given that Berlusconi has been regularly losing support, is for him to resign in the face of too much opposition within the ruling coalition. 

Financial markets have also not been kind.  On Monday, the spread between the 10-year Italian BTP benchmark bond and the equivalent German issue jumped to 388 basis points.  The near term high for this spread is slightly more than 400 basis points.

Moody’s dropped the rating on Italian bonds three notches on October 4: Standard & Poor’s downgraded the Italian debt about a month before.  The rating agencies are poised for another possible lowering of the rating. 

Mario Calabresi, editor of Turin’s La Stampa newspaper stated the “we (Italians) are the sick man of Europe…”  As I stated in my last blogpost, the situation in Italy is comparable to the situation in Greece.  This can be seen as the cause of the current hostile focus on Italy by others in the eurozone. 

In this previous post, I argued that officials of the EU may finally be accepting the seriousness of the problem they face; that the issues now faced by the eurozone are solvency issues and not liquidity issues; and that the problem cannot be solved just on a state-by-state basis. 

Can Berlusconi bring this off?

I’m not sure he can.  But, this latest humiliation may really bring home to some Italians that they are not going to get “off the hook” this time.  Like Greece, efforts to bring on the reforms in Italy will result in more protests and riots like the ones seen in Greece and elsewhere in Europe. 

 
The times they are a changin’…

I’m not sure that the changes that are coming are the ones imagined by Bob Dylan when he wrote this line.  But, times have changed and societies and cultures are going to have to adapt.  Not everything is happening in “the Arab Spring.”       

European officials really seem to be getting serious now.

“European negotiators have asked Greek debt holders to accept a 60 per cent cut in the face value of their bonds, a hardline stance that far exceeds losses agreed in a deal between private investors and eurozone authorities three months ago.“ (See http://www.ft.com/intl/cms/s/0/ff349958-fe58-11e0-a1eb-00144feabdc0.html#axzz1bjQzVRpl but also see my post of October 23, http://seekingalpha.com/article/301369-europeans-facing-more-of-a-haircut-than-preciously-thought.)

I am thinking that many European officials are tired, tired of going over the same thing month after month after month.  Maybe, just maybe they are realizing that unless they really get their “arms around the problems” that the difficulties will just continue to march along.  In essence, maybe, just maybe, they are coming to the conclusion that “kicking the can down the road” doesn’t work. 

Let’s hope Mr. Berlusconi sticks to his guns and is able to pull off the reforms needed to allow Europe to move ahead.  Time really seems to be running out.    

Italy is the Key in Europe

It seems to be boiling down to this.  Italy and its prime minister Silvio Berlusconi are the evolving focus of any acceptable solution to the European sovereign debt crisis. 

There are, I believe, two reasons for this focus.  First, Italy is the third largest economy in the European Union.  Thus, moving it into the spotlight leapfrogs the problems of Spain and Portugal and others in terms of impact.  If Italy can be “tamed” then Spain, Portugal, and others will have to fall in line.

Second, Italy, within the European Union, is most like Greece in terms of fiscal irresponsibility, governmental patronization, and lackluster economy.  If both Greece and Italy take steps to correct their situations, then other troubled countries can justify stronger efforts to straighten out their problems as well. 

Another factor is that Silvio Berlusconi has become a characterization of European leadership…or the lack thereof…given his personal as well as his public tribulations.  And, this does not include his recent disputes with others, like that with French president Nicolas Sarkozy, over the makeup of the board of the European Central Bank.  Berlusconi, it seems, must be brought into line...even though he is just barely hanging onto power now.  

By focusing on Italy, the European Union is, in a sense, attempting to “get its arms around” the problem.  The EU efforts of the past have started with the smaller countries with the idea of working up the ladder as the need arose to deal with larger and larger countries.

By bringing Italy in at this time, the EU seems to be admitting that the problem is more fundamental than it had assumed in the past and that the problem is one of solvency and not the liquidity of the sovereign debt.  

Furthermore, the EU seems to be saying that more fiscal coordination needs to be achieved within the European Union itself and to gain this coordination, even the larger countries, like Italy, must submit to greater oversight and community discipline than had originally been built into the organization.    

With the crisis, it has become more and more obvious that for the countries of the European Union to really benefit from the creation of a common currency, greater fiscal union must be achieved as well.  Painful as it may be to some to accept this reality, I don’t believe that there is really much support anywhere for the breaking up of the currency union.

The European Union may finally be getting someplace, although I don’t want to be too optimistic.  Up to this point, the EU has just been “kicking the can” down the road.  It has continually avoided the seriousness of the situation; it has not accepted the reality of the solvency issue; and it has attempted to deal with problems piecemeal. 

As a consequence, many analysts have claimed that it would be better for some nations to leave the currency union or for the Euro to be eliminated all together. 

The fact is, the benefits of the currency union have been sufficiently great that the members of the EU really don’t want to see it go away. 

The “big bump in the road”, however, has been the need for sovereign nations to give up some of their sovereignty on the fiscal front, something they have, understandably, been reluctant to give up.  As a consequence, the path to greater fiscal union has been winding and painful.  No one, willingly, wants to look like the pansy.

By putting the pressure on Italy, the European Union is accepting the seriousness of the situation; it is accepting that the primary issue is one of solvency and not liquidity; and it is finally trying to encircle the problems that exist, not deal with them one-by-one.

This does not mean that the crisis in Europe is over.  There are still many “bumps in the road” that must be smoothed over. 

However, to me, putting Italy into the spotlight raises some hope that the officials in Europe (I am not willing to call them “leaders” yet) may finally be moving in the right direction.

Europeans Facing More of a "Haircut" Than Preciously Thought

News is leaking out that the “haircuts” on European Sovereign debt are going to be greater than imagined just several weeks ago!  “EU looks at 60% haircuts for Greek debt.” (http://www.ft.com/intl/cms/s/0/66bdcbc0-fc11-11e0-b1d8-00144feab49a.html#axzz1bRwsVH3F)

Three months ago European officials agreed to a 21 percent haircut.  Then, in the last several weeks, the figure moved to around 50 percent.

And, still officials are dawdling.

European banks are troubled, and we hear about how the “French Banks Fought Oversight.“  Seems as if French banks and French regulators consistently ignored the reality of the situation within the banks claiming that no problems ever existed. 

Of course, bankers are notorious for claiming that problems do not exist on their balance sheets!  But, this is not new. (See my http://seekingalpha.com/article/300076-european-bankers-balk-at-big-write-downs.)  The bankers’ denial of any problems on their balance sheets is maintained right up to the time hey begin to argue that “It was not our fault!”

The problem I have with all this is that attention is being deflected from the real issues while blame is being diverted from the real culprit.

The real culprit, to me, is the post-World War II attitude in America, the UK, and Western Europe that the creation of debt, especially by governments, could keep unemployment at low levels and this would end the possibility of social unrest caused by masses of unemployed persons.  The result was that the latter half of the twentieth century became the “poster child” for the benefits of what can be called credit inflation. 

Creating debt, especially government debt, was not just a policy of the left, but it was also the policy of the right.  The creation of debt would resolve almost all social issues since it kept people at work.  This would also help politicians get re-elected.

In the 1960s we added to the goal of keeping people working the goal of seeing to it that every family owned their own home.  This was especially the case in the United States.  I was working for a cabinet secretary in the early 1970s in a “conservative” administration, and one of the major goals of this administration was the development of mortgage-backed securities.

The reason for the development of this instrument was certainly not an economic one.  The reason for the development of the mortgage-backed security was to get politicians re-elected.  The argument was that if more Americans owned their own home, the more willing they would be to re-elect those Senators, Representatives, and Presidents that supported this goal. 

The government’s development of the mortgage-backed security, of course, brought several new things to the financial markets, like ‘slicing and dicing’ cash flows, that paved the way for the financial innovation that was to take place later in the century.

Of course, the major driver behind all of this was the continual efforts of the national governments to create credit through deficit spending to hire large numbers of people themselves, to almost continuously stimulate the economy to keep unemployment low, and to continue to find ways to put more and more people into their own homes. 

This is the essence of credit inflation!  And, the central banks, fundamentally, helped the national governments to write the checks.

The undisciplined creation of debt, however, does not end well.  This is the story that Carmen Reinhart and Kenneth Rogoff tell in their book “This Time is Different.”  And, for the United States, the UK, and Western Europe, this time was not different and financial crisis arose.

The point I am getting at is that the resolution of a financial crisis is not a unique action.  However, many of those in authority are crying out “This time is different”!

One of the boldest “criers” is Fed Chairman Ben Bernanke.  I have written my opinion of him in an earlier post. (http://seekingalpha.com/article/300076-european-bankers-balk-at-big-write-downs)  But, Mr. Bernanke is not the only authority at the central bank that is searching for a new or better way to conduct monetary policy. (http://professional.wsj.com/article/SB10001424052970203752604576643510352250474.html?mod=ITP_pageone_0&mg=reno-secaucus-wsj)

Gillian Tett also writes in the Financial Times that “Central Bankers must update outdated analytical toolkit.” (http://www.ft.com/intl/cms/s/0/877b7bfa-fb21-11e0-bebe-00144feab49a.html#axzz1bRwsVH3F)  

Let me just say in answer to this situation we are in: This time is not different!

The problem is too much debt!  The cause of the problem was 50 years of credit inflation in the United States, the UK, and Western Europe.  This debt must be worked off and it takes time to work off excessive amounts of debt.  Again, I recommend you check the Reinhart and Rogoff book.  I have also just written a post on this: http://seekingalpha.com/article/300450-the-u-s-economy-will-continue-to-grow.

And, the lessons from this experience are not new.  Don’t issue too much debt!  Don’t just focus on short-run goals…like fiscally stimulated low unemployment, like everyone owning their own home, like governments hiring all their own supporters…and so on and so forth.

The problem is not financial innovation or greed or speculators.  These things will never go away. 

The problem has been that the credit inflation created in the last 50 years has created huge incentives to develop financial innovation, to exercise greed, and to benefit from speculation.  And, in the frenzy, things got out-of-control.

That is where we are today.  The haircuts that are now necessary are large and if something is not done about them soon, the haircuts will get even larger!  What if the write-down on Greek bonds were 90 percent?  What if the write-down on the bonds of Italy were 50 percent?  Portugal…60 percent? Spain…?  And, France…?

Over the last fifty years or so, people in the United States, the UK, and Western Europe have been living pretty well.  They can live well again.  But, we need to get away from Keynesian policies that promise something for nothing and return to some fundamentals that have played well over the years.

This time is not different!  Discipline and integrity are winners and have always been winners.  But, in a state of chaos, returning to discipline and integrity is difficult and painful.  The historical lesson, however, is that if people do not return to a condition of discipline and integrity the pain and suffering does not end…and in many cases it will only get worse!