The European Model: Broken Beyond Repair?

I am really tired of the German bashing!

The model for the Euro was unsustainable.  But, the lessons learned from the effort should not be taken lightly.

The major lesson from the experiment with the Euro is that a currency area cannot be set up without a central political body that is strong enough to enforce the rules of the currency area.  One can have separate states within the area, but, as in the United States, there must be a political union with enough authority to dominate the individual components of the area.

A second lesson from the experiment is that the economic model based upon “social engineering” is not sustainable.  The German economic model of low inflation, high labor productivity, and fewer government handouts has worked better than the model that includes substantial credit inflation, an inefficient private sector, and bloated government payrolls. 

And, as usual, the “losers” in the game cry foul against the successful. 

“The press review from around Europe does not make pleasant reading for the German foreign ministry these days.  ‘Look at this stuff, it’s just unacceptable,’ laments one diplomat—pointing to a front-page article from Il Giornale, an Italian newspaper owned by Silvio Berlusconi.  The piece links the euro crisis to Auschwitz, warns of German arrogance and says that Germany has turned the single currency into a weapon.  The Greek papers are not much better.  Any taboos about reference to the Nazi occupation of Greece have been dropped long ago.

Across southern Europe, the ‘ugly German’ is back—accused of driving other nations into penury, deposing governments and generally barking orders at all and sundry.

There is also a much more polite form of German-bashing going on at the official level.’ (http://www.ft.com/intl/cms/s/0/9d38ffee-5639-11e1-8dfa-00144feabdc0.html#axzz1mGnbTALH)

Economics, at one time, was defined as the study of the allocation of scarce resources.  That is, there are limits to what a country can attain given the amounts of human capital and physical capital that are available to it. 

Over the past fifty years, many countries came to believe that they had overcome these limitations and through credit inflation and social engineering they could achieve something beyond the boundaries set by the amounts of human capital and physical capital that existed.

Some of these programs included government created credit inflation that kept workers locked in jobs that were becoming legacy positions and that also promoted a home ownership scam that seemingly created middle-class piggy-banks; government hiring practices that resulted in excessive overstaffing of bureaucratic agencies (about one-third of the Greek workforce is in the public sector); and pension benefits that allowed for very comfortable early retirements. 

The economies of these countries just did not have the resources to sustain these programs. 

If everyone is following these policies then everyone is basically in the same boat.

However, a problem occurs if one or more other countries do not follow the same policies. 

The eurozone is having a problem because Germany, for one, has not taken the path most travelled.  And, over time, their more disciplined approach came out on top.

Germany now has the wealth, the resources, that others don’t.  Consequently, those that don’t have the wealth and are now struggling believe that Germany should compensate them for Germany’s success. 

The article quoted above states that the weaker countries in Europe are asking three things from the Germans: first, to commit more money to a European “bailout” fund that would be “so large that it would frighten the markets from speculating against southern European bonds”; second, to commit to Eurobonds to make the debts of individual countries the debts of the eurozone itself; and to stimulate the German economy so that Germans would buy more goods from southern Europe.

These requests, in my mind, are totally off-the-wall!

The Germans should not give in on these issues and they should maintain their position of strength.  And, the German-bashing should stop!

The eurozone is not going to get stronger by making every one of its members weaker!

This is because the eurozone is not the only game going on in the world.

Other areas in the world are maintaining their discipline and can only benefit, competitively, from a weaker eurozone.  Need I mention China?  And, Brazil?

And, these other areas of the world are growing in relative economic strength as Europe fights its own little family fights.  The pressures coming from this competition are not going to go away and Europe, as a whole, may have already postponed dealing with its problems for so long that it may still be years away from a resolution in which it becomes as competitive as it needs to be in the world of the 21^st century.

I still fail to see anyone in Europe that I would call a leader.  Consequently, I find it hard to defend the continued existence of the Euro, as we now know it.  At this point in time, I see several countries leaving the Euro over the next couple of years.  I see a much-diminished role for the eurozone in the world, both economically and financially.  I also see economic social engineering receding as a government policy in the western world even though Paul Krugman and Joseph Stiglitz will still be around.  The era of economic social engineering is past its prime, even though this fact is not fully recognized yet.

The United States should be grateful to the eurozone for the way it has conducted itself, otherwise we would be talking more about the fifty-year weakness in the value of the US dollar.       

Where Does Sovereign Credibility Come From? The European Sitaution

As usual, when Bob Barro of Harvard writes something it usually contains some provocative ideas.  In the Monday morning Wall Street Journal, Barro writes about how Europe might get out of the Euro. (http://professional.wsj.com/article/SB10001424052970203462304577134722056867022.html?mod=ITP_opinion_0&mg=reno-secaucus-wsj)

What interested me most in Barro’s piece was the emphasis he placed on the credibility of the organizations that issue a currency. 

In essence, as I read the article, Barro argues that the credibility of the Euro comes from those within the eurozone that are fiscally sound and carry those that are not fiscally sound, the “free riders”, along with them. 

This credibility is maintained for as long as the “free riders” conduct their irresponsibility within limits.   In fact, this is what the original charter of the eurozone called for…limits to how irresponsible the “free riders” could be.

But, the limits must be enforced.

“Greece…has been increasingly out of control fiscally since the 1970s.  But instead of expulsion, the EU reaction has been to provide a sufficient bailout to deter the country from leaving.” 

The bailouts have become serial, as bailouts have also been given to Portugal, Ireland, Italy, and Spain. 

Thus, the only way credibility can be maintained is for Germany to continue to be fiscally strong while the union continues to provide bailout packages that will carry the “free riders” along for as long as possible.

Meanwhile, the internal effort of the members of the eurozone has been to create a stronger “fiscal” bond within the zone itself…ultimately moving to a “centralized political entity” that will oversee the fiscal and currency policy of the whole eurozone. 

Europe, to achieve such a “centralized political entity”, would have to overcome many, many issues that have existed on the continent for a long time.  For one, the internal rivalries that have existed for centuries would have to be overcome.  Already the resentment against Germany has grown as Germany has become a more demanding partner within the union.  Even statements like “Germany is achieving through economics what it could not achieve militarily at an earlier date” demonstrate some of the underlying emotions that exist on the continent.  Then you have the cultures, languages, and other hurdles to overcome to achieve the needed unity.

Even so, Barro continues, in the shorter run, the credibility of the nations is vitally important because of the sovereign debt that has already been issued by the governments of Europe and that rest on the balance sheets of the banks within the eurozone.  This is the reason there is rush to achieve the near term austerity in the budgets of Italy, Spain,…and France…among others. 

Greek debt is now yielding more than 34 percent on its ten-year bonds.   Portuguese bonds are yielding more than 13 percent.  The debt of Italy is yielding more than 7 percent.  And Spanish bonds are above 5.5 percent.  These rates are unsustainable!

French debt is yielding around 3.5 percent and the rating agencies are soon expected to remove their AAA rating.

The status of this debt is important because, “the issue that has prompted ever-growing official intervention in recent months has been actual and potential losses of value of government bonds of Greece, Italy and so on.  Governments and financial markets worry that these depreciations would lead to bank failures and financial crises in France, Germany, and elsewhere.”

Credibility is lacking because “it is unclear whether Italy and other weak members will be able and willing to meet their long-term euro obligations.” 

Not only is the banking system threatened by this lack of confidence, the uncertainty that exists surrounding the future structure and performance of this area does not contribute to the achievement of stronger economic growth.  If anything, this uncertainty works to reduce growth.

Only as independent nations with their own currencies would these countries be able to meet their own obligations and achieve the credibility a nation needs to function within the global economy.  “This credibility underlay the pre-1999 system in which the bonds of Italy and other eurozone countries were denominated in their own currencies.  The old system was imperfect, but it’s become clear that it was better than the current setup.”

The issue is one of credibility. 

Right now, Germany seems to possess credibility.  But this credibility is based on its maintaining the position of fiscal responsibility it has already achieved.  And, this is just what the Germans seem to be doing. (“Germany Resists Europe’s Plea to Spend More,” http://www.nytimes.com/2012/01/09/business/global/germany-resists-europes-pleas-to-spend-more.html?_r=1&ref=business)  

As long as the current economic structure exists for the eurozone, the credibility of the eurozone will depend upon it’s ability to provide sufficient “band aides” to piggy-back on the credibility of Germany.   My guess is that it will become harder and harder for financial markets to buy-into this piggy-back arrangement. 

Credibility requires the provision of actions that backup promises.  Barro is suggesting that the only way that the fiscally irresponsible will become credible is for them to be “out-on-their-own” again where they will have to be totally responsible for their own actions.  Unless this happens, there is too much historical baggage carried by the eurozone that will not be overcome.      

"In the Real World Creditors will Always Have the Whip Hand with Debtors"

The lesson that never seems to be learned in the real world: “In the real world creditors will always have the whip hand with debtors.” (http://www.ft.com/intl/cms/s/0/f05edd3e-27ee-11e1-a4c4-00144feabdc0.html#axzz1i1eGuNp3)

John Plender writes in the Financial Times, “From the wreck of the sovereign debt crisis Germany has unquestionably emerged as Europe’s pre-eminent power.  And a central tenet of the German solution to the crisis—for it is primarily a German solution—is that other eurozone members must be recast in their mold of fiscal orthodoxy and financial conservatism.”

He concludes his essay, “So Germany rules and southern Europe should prepare for austerity, followed by deflation, unemployment and, eventually, civil strife, if the eurozone holds.”

Europe…and the United States…have experienced roughly fifty years of Keynesian-type credit inflation.  The public debt in these areas expanded at a pace at least double the rate at which the real economy has grown.  Private debt in all of these areas grew at even faster rates than did the public sector debt. 

During this period of credit inflation, risk-taking increased, financial leverage exploded, and financial innovation and financial engineering accelerated at a pace never before seen. 

And, in the end, the weight of all these developments proved to be unsustainable.

While it was going on, the credit inflation was delightful…especially in the country owning the reserve currency of the world.  Oh, there were cyclical swings during this time period, yet, all-in-all, everyone grew together.

Where was the pain connected with being a debtor?

Well, until the music stops, everyone, especially the debtors, keeps dancing and everyone has a pretty good time. 

There were some undercurrents of pain.  Underemployment in these Europe and the United States more than doubled from the 1960s to the 2000s.  Income inequality increased dramatically as the more astute or wealthy took advantage of the credit inflation whereas the less wealthy could not. 

But, as “Chuck” Prince, the Chairman and CEO of Citigroup, put it: “As long as the music is playing you have to get up and dance.”

And, what about the financially prudent?

Well, they had to bend to the times…for they had to dance as well.  If the way to increase or maintain ones return on equity comes from assuming riskier assets, increasing financial leverage, or financing long-term assets with short-term liabilities, the prudent had to play the game to some degree or face the real fact that money was going to move to those producing the greater return.

Even Germany played the game! 

As Plender points out, “Germany was the first in the European monetary union to break the stability and growth pact rules on deficits and debt.”

But, the Germans pulled it together…and now they are in the driver’s seat.

And, we see this to be true in the banking sector…and in the manufacturing sector…and with individuals and families.  When the bubble bursts, those with their balance sheets in the best shape control the future. 

“In the real world…”

Those that did not get their act together face the pain…and, they even come to resent…and dislike…those that did get their act together.  This is where civil strife can come into the picture, where the discontented can attempt to “occupy” the other.

The lesson for the new year…and for every new year…is that one needs to be careful about the debt one accumulates.  Too much debt can always come back to haunt you.  I know that the phrase “too much debt” is only relative, but, it seems that over time, having less debt than others can be to the benefit of the prudential. 

Remember, the general rule for winning the Super Bowl is to have the superior defense!

Happy New Year!

The Problem is Germany

Last Friday, December 9, I ended my post with this concern: “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.” (http://seekingalpha.com/article/312920-initial-verdict-on-european-summit-the-can-got-kicked-further-down-the-road)

Tuesday, in the Wall Street Journal, Alan Blinder lays it on the line: “the eurozone has a big, visible Greek problem, which is a result of failure.  But, it also has a far bigger, though less visible, German problem, which is a result of success.” (“The Euro Zone's German Crisis: Blame Teutonic efficiency for what ails Europe. The other countries just can't compete”: (http://professional.wsj.com/article/SB10001424052970203430404577094313707190708.html?mod=ITP_opinion_0&mg=reno-secaucus-wsj)

“When it comes to productivity, Germany has simply pulled away from the pack…Since 2000, German unit labor costs have risen about 20 to 30 percent less than unit labor costs in the other euro countries.  That gap has left Germany with a large intra-Europe trade surplus while most other countries run deficits.”

The referee could blow the whistle and call a foul…Germany is guilty of mercantilism!

On Wikipedia, mercantilism “is the economic doctrine in which government control of foreign trade is of paramount importance for ensuring the prosperity and security of the state. In particular, it demands a positive balance of trade. Mercantilism dominated Western European economic policy…from the 16th to late-18th centuries.”

But, mercantilism has not been an overt policy of the German government.  In fact, over the past decade or so, Germany has been trying to get its act together, dealing with putting two separate nations together as well as dealing with the newly constructed common currency area. 

But, Germany is Germany with a strong work ethic and a desire to pull things together with “thorough-going-labor reforms in the last decade.” 

It has not conducted a mercantilist economic policy, but the results have been roughly the same. 
Besides being ahead of most of the rest of its eurozone partners in terms of labor productivity, Germany also had the lowest rate of inflation.  The highest?  Well, of course Greece…and Spain…falling off to France, who had the second lowest rate of inflation.

The way out of this for the non-German eurozone countries?  Debt deflation!

The eurozone countries have one currency, so there can be no adjustment of individual currencies to revive some competitiveness among the nations. 

The eurozone countries have one central bank, so the individual countries cannot use monetary policy to correct their individual situations.

And, the eurozone countries in trouble have foolishly created so much debt in order to build up their economies through credit inflation that this avenue of spurring on economic growth has been closed.

According to Blinder, the only path left is 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.”

Blinder closes, “Sadly, this may be the most likely way out.”

We knew it…the whole situation has been caused by those damn Germans!  They couldn’t get what they wanted by military means so they resorted to trickery…they worked hard, they innovated, they reformed their labor laws, and they didn’t issue too much debt.  Damn them!

If we blame the Germans, however, as I reported above, we…the Europeans…are just living off the same prejudices and wars that were fought in the past. 

Again, to quote Stephen Covey once more…”if we believe the problem is out there, that is the problem.”

This situation may be an uncomfortable one and the resolution of it may be “incredibly difficult and painful…and protracted.” 

Maybe that is what we need to work with.  Maybe the non-German countries need to get their budgets under control, get their labor laws reformed, get their educational systems up-to-speed, and move into the twenty-first century

Maybe the eurozone countries need to actually resolve the sovereign debt crisis, create a fiscal compact, and get on with these other problems that really need to be addressed.  

One final note…the United States is still benefitting from the role it plays as the country with the reserve currency of the world.  United States Treasury securities are still the place to go when there is a “flight to quality” and international investors become overly concerned with risk. 

But, let me just say that the world is becoming more competitive.  There are other countries in the world that may be less generous, more mercantilist.  There are other countries in the world that may be honing their productivity, their economic strength, their currency strategy to establish trade balances in their favor in order to change the relative power structure of the world. 

The United States is going to feel this is the future and needs to take a lesson from what is happening in the eurozone.  The unfortunate thing is that unless something is done the United States is not going to be in the position in the world that Germany now finds itself within the EU.    

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.

China and Others are Waiting to See How the West Solves Its Problems

“Germany’s continued prosperity has helped fuel growing anger in countries like Greece and Spain against what is increasingly viewed as harsh German domination.  More and more, Germany is cast in the role of villain, whether by protesters in the streets of Athens or by exasperated politicians in the halls at the Group of 20 meetings in Cannes, France.” (http://www.nytimes.com/2011/11/16/world/europe/germanys-success-and-advice-anger-european-partners.html?_r=1&hp)

This quotes reminds me of a quote of Warren Buffet’s: You have to wait until the tide goes out to find out who is wearing a bathing suit and who is not wearing a bathing suit.

During an extended period of credit inflation like the one experienced by the United States, the UK, and Europe over the past fifty years “success” seems to apply to everybody.

An example I have experienced in my years as a bank executive is the area of residential real estate construction.  During this fifty-year period of credit inflation it seemed as if almost everyone and his brother or sister could build houses and become a successful real estate construction executive. 

One found out, however, when the credit inflation stopped who was a good builder and who was just coasting along on the inflationary wave and who really built very good houses. 

And those that just “put up” houses resented the success of the really good builders and gripped about those that continued to prosper when times were not so lush.

We are seeing this shake out in Europe these days as Germany, known for the discipline of its people and the work ethic embedded within the society, continues to prosper with a relatively healthy economy and a strong export component of its Gross Domestic Product. 

“When the tide goes out” there is a higher probability that the hard working and disciplined nation will come out on top.  And, we are seeing that in the case of the eurozone. 

The difficulty in maintaining that discipline and commitment to hard work is that during the period of credit inflation you see other nations getting by with a lot less discipline and a lot less work.  It is very easy during this time period to reflect on the fact that the others are getting by much more cheaply and are still doing pretty well.  And, the move to the “easy side” does not have to come all at once…it is easy to give up a little here and a little there…and slide, incrementally into the opposite pattern.

One can think of the comment by former Citigroup Chairman and CEO “Chuck” Prince who famously said that one must keep dancing as long as the music is playing. 

As long as the period of credit inflation continues, increased risk taking, increased financial leverage, and increased interest rate risk taking pays off.  Financial betting also pays as manufacturing firms, like General Motors and General Electric, reduce their focus on production and increasingly become financial companies.  

Some nations and some corporations do maintain their discipline during these times and although they indulge in the credit inflation game, they control their risk exposure so that once the “dancing” stops, they can maintain their position and continue to prosper.  JPMorganChase is an example of this.  Also, there were a number of manufacturing companies that did not “over indulge” in the financial frenzy created by their governments.  These companies now are sitting on piles of cash, buying back their stock or engaging in a very “ripe” acquisition market. 

During such an extended time, one cannot totally ignore the environment of credit inflation that has been created.  The task is not to be overcome by the exuberance and excesses of the time, and maintain and control the exposure of the nation or corporation to the environment and incentives that has been created by the economic policies of the other governments and corporations.

There is no question that this is a very hard thing to do.  Yet, that is what the ultimate winners do!  Super Bowl champions are invariably built on strong defenses with a good offense.  The winners do not often come from teams that are just built to score a lot of points.  Companies that continually push the edge of financial leverage and risk-taking to gain a few more basis points for their return on equity do not survive over the longer-run.

When the bubble bursts, as it has done now, those that have maintained their discipline throughout the “loose” times are the ones that are usually left to dictate the terms of the future, whether it be the future of nations, or, the future of industries.  And, those that achieve that dominate position are not liked, are resented, and are only grudgingly followed.       

“As the overall health of Germany’s economy and its fiscal position widen the rift with Europe’s poorer periphery, Germans have a ready response.  They say that they already made the structural changes in work-force rules and pension reforms that they are now recommending for the slow-growth countries, and that, by the way, they actually pay their taxes. So if the laggards want Germany’s money, they have to play by German rules.”

This is hard-nose stuff!  And, it seems heartless to those that have to go though the “wrenching” economic changes that are being proposed for the “laggards”.  For, what about those people who were just “unlucky” and were in the wrong spot at the wrong time.  And, what about the “disadvantaged” that had nothing to do with the regime of credit inflation? Just saying that the governments should have been thinking about these people when they went on their credit inflation binge is not very satisfying to these people.

Yet, nations…and corporations…and people…that control their excesses and remain disciplined over time have a better track record than those that don’t.  The loss of control and the loss of discipline seem to come when nations…and corporations…and people…become short-sighted and think that they can continuously maintain short-term gains over the longer-haul. 

But, the philosophy that we should not worry about the longer-haul because “in the long-run we are all dead” is not pragmatic…either for us…or for those coming after us.  The long-run does come about…and we pay…and we may pay a lot…if we have just focused on the “highs” we get from short-term excesses.

The United States, the UK, and Europe are all paying for the excesses of the credit inflation of the past.  The question that remains to be answered is whether or not these excesses will be corrected in the near term.  Others…China…Russia…Brazil…India…and others…are waiting to see what happens.  

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!

Europe is Still Struggling

The debt deal cut in Europe last week apparently did not get out in front of the markets through its own actions.  Interest rates and interest rate spreads over the German 10-year bond rate remained at or near Euro-era highs. 

There were a lot of questions still floating around financial markets last Friday.  (See my post on Blogspot of October 28, 2011: http://maseportfolio.blogspot.com/.) But just where is the weak spot in last week’s deal…the write down of Greek debt?  The recapitalization of the banks?  Or, the European bailout fund?  Or, all of the above?

The point still remains that financial markets are not satisfied.

The yield on Italian 10-year bonds closed at 6.11 percent yesterday, a new euro era high and this was 411 basis points above the comparable German bond.  The yield on Portuguese bonds on Friday was almost 1200 basis points above the German bond, also a new euro era high.  And, yields on Greek bonds, Spanish bonds and other stay at lofty spreads above the German bond.

It is one thing when credit inflation pervades the financial system.  Credit inflation provides incentives to create debt, to speculate, to absorb more risk. 

When credit inflation is checked, as it is at the present time (although not through the explicit desire of a large number of governments) the fiscally and economically strong dominate.  That is why Germany is currently in such a strong position in Europe.

Credit inflation like we have experienced over the past fifty years encourages financial leverage, excessive risk taking, and cutting corners.  The incentives that exist at such times allow governments and businesses and banks to issue debt and leverage up…and the credit inflation buys them out. 

Speculation thrives in a time of credit inflation.  I read an article like that of Andrew Ross Sorkin in the New York Times this morning (http://dealbook.nytimes.com/2011/10/31/its-lonely-without-the-goldman-net/?ref=business),  an article that discusses the trading and “big bets” placed by such names as John Corzine, John Thain, Robert Rubin, and J. Chris Flowers.  These individuals benefitted by taking on more and more risk during the time of credit inflation and financing this risk taking with lots of leverage, and especially short term debt.

The morning papers are filled with the news of the latest bets placed by John Corzine at MF Global.  Unfortunately, the environment was not one that was conducive to the recently placed bets of Corzine.

Furthermore, a period of credit inflation is a time when people cut corners on the truth, push hiddenness a little more, and engage in schemes that are on the edge of being legal if they are legal.  Greece hid its financial condition for a long time before it had to “fess up.”  Italy has not been fully forthcoming concerning its financial affairs.  Citigroup hid mountains of questionable assets “off-balance sheet”.  And, of course, look at all the instances of insider trading and Ponzi-schemes that have surfaced over the past few years.

As Chuck Prince, former CEO of Citigroup so famously stated: As long as the music is playing, you have to keep dancing.

When the music stops…

Or, as Warren Buffet has said, you have to wait until the tide goes out before you find who is swimming without a bathing suit!

Well, the music has stopped…the tide has gone out…

And, we are observing those who where not wearing bathing suits and the scene is not very pretty.

The financial markets are saying that the officials of Europe have not gotten out ahead of the situation…they are still behind.  And, since the tide has gone out, there is no credit inflation to buy them out of their situation.  As a consequence, some time or another, they are going to have to finally address the insolvencies that exist. 

And, it will be the strong that control the situation. 

Germany will be one of the strong…maybe gaining a position in the twenty-first century that they could not achieve in two world wars in the twentieth century. 

Will America be one of the strong?  People are raising questions about the ability of the United States to lead in the twenty-first century.  See John Taylor’s op-ed piece in the Wall Street Journal this morning: http://professional.wsj.com/article/SB10001424052970204394804577009651207190754.html?mod=ITP_opinion_0&mg=reno-secaucus-wsj.

It does not appear that Europe has made it yet.  Consequently, there will still be financial market turmoil, social unrest, and political dislocation.  The European continent had its fun over the past fifty years financed by lots of debt.  Now, it must pay the debt collector…or default.

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.