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.      

No. 1 Issue of 2012: Recession in Europe

I believe that the number one economic issue for 2012 will be a recession in Europe.  I don’t see how this will be avoidable. 

The sovereign debt crisis in Europe has not ended and a lot of the debt is turning over this year and must be financed in the face of greater scrutiny by the rating agencies. 

The solvency problems in the European banking system has not been resolved and with more severe capital requirements and a rising level of troubled loans on their balance sheets, commercial banks are not going to be in the mood to increase lending levels.

And the governmental austerity programs of Greece, Italy, and Spain are just beginning to hurt.  The pain will only rise over the next year or two.

Furthermore, the lack of leadership on the European continent (and elsewhere) is astounding!  How do you resolve a difficult situation when there are no leaders around to realistically deal with the problems embedded within the situation?

A European recession has a high probability of occurring, but the depth of the recession is still to be determined.  On the surface, one might think that the recession would be relatively shallow, but there are other factors one must filter into the picture that adds to the uncertainty of how deep the recession might be.

Given this picture as the most likely leading scenario for 2012, I believe that we must further focus our sights on two other factors. 

The first of these is how the recession might spread to other nations.  Contagion is obviously the biggest concern here.  If a recession hits an area as large as the eurozone, even if it is a modest one, the effects of that recession will spread to others.  The exports of non-European nations will drop.  And there will be financial markets consequences. 

It is highly unlikely that a European recession will be contained just to the continent.  And, since many of Europe’s trading partners are already facing economic expansion that is modest, at best, the repercussions could spread to a relatively large part of the world.

 The second factor is even more disturbing.  If we have a European recession in 2012, given the austerity programs that are being embedded in the economic policies of eurozone states, the likelihood that social unrest in these nations will accelerate both in the current year and beyond. 

We have already seen outbursts of social unease in 2011 and with the increasing information on greater income inequalities, higher levels of unemployment, lower pensions, and so forth, that will be in the news, social unrest can only increase. 

But, these protests will have the examples of the Arab spring to build upon.  As was seen in 2011, the use of modern information technology can only strengthen the capability of protesters to organize and to disrupt.  What happened in 2011 has not been lost on the discontented of the developed world.

And, what happens if a European recession spreads to other areas of the world.  The seeds of protest have already been planted in many areas, including the United States.  Just mention the word “occupy” and you will get your response.

Which leads me to one final point.  I believe that modern society is now going through a period of substantial transition, and, like most periods of substantial transition there will be a lot of suffering as the “new world” emerges and there will be a substantial period of uncertainty as we grapple with the issues and move into this “new world.”

Of course, this will be one of the major problems we have to face…the problem of identifying what needs major changes and what needs only minor adjustments.

With certainty, however, I will argue that the evolving information technology is going to play a huge role in whatever results.  People are going to be dealing with more and more information and they will have this information is “real time.”  There will be much greater connectivity between people.  Due to this there is going to have to be greater openness and transparency in life and this is going to force major changes on the way we do things and the speed at which people react.  Governments are going to have to respond to this.  Corporations are going to have to respond to this.  And, whole societies and their social structures are going to have to respond to this. 

Changes in the availability of information have resulted in major upheavals in the world from the use of mobile type in printing which occurred around 1450 CE and resulted in societal changes like the Renaissance and the Reformation…and the Enlightenment…to the creation of the typewriter, the telephone, the telegraph, the radio, and television.

In a very real sense, I believe that a worldview is passing.  A recession in Europe during 2012 would accelerate changes that are already in motion.  If I am correct, this conclusion does not present a real comfortable picture for the next five to ten years but in terms of the human suffering that will result and in terms of the needs involved in adapting to the changes.    

U. S. Businesses Shop Europe

“As Europe struggles with its debt crisis, American businesses and financial firms are swooping in amid the distress, making loans and snapping up assets owned by banks there—from the mortgage on a luxury hotel in Miami Beach to the tallest office building in Dublin.” (http://www.nytimes.com/2011/12/26/business/us-firms-see-europe-woes-as-opportunities.html?_r=1&scp=2&sq=nelson%20schwartz&st=cse)

Where in our current understanding of macroeconomics does it indicate that a sovereign debt crisis might end up with foreign interests owning large chunks of a country’s physical assets?  How much of Ireland will United States interests buy?  How much of Spain will Middle Eastern countries end up owning?  And, how much of Italy will China possess?

Macroeconomics just cannot pick up the complexity of real economies.  Too much of the reality of an economy takes place at the micro-level and cannot be comfortably incorporated into the simple structures of the aggregate models of the economy. 

Macro-models just cannot include all of the incentives that are created within the total economy that lead to results that can even produce contradictory outcomes to what the macro-economists had been predicting. 

One of the most egregious results of the past fifty years is the prediction of the macro-economist that inflation can help the working classes and the middle classes.  Yet fifty years of credit inflation in the United States produced exactly the opposite effect in that the income/wealth distribution in the U. S. became highly skewed toward the wealthier in the society.

For one, the economists used aggregate models to show that there was a favorable tradeoff between employment and inflation.  The policy implication: if a little more inflation can be created then more people will be hired and unemployment will decline.

These models did not pick up micro-behavior that indicated that the “less wealthy” could not protect themselves from credit inflation whereas the “more wealthy” could not only protect themselves from credit inflation but could actually benefit from it.

Furthermore, these models did not include the fact that the credit inflation would provide incentives for manufacturing companies to move more into financial services while shifting their focus away from their historically productive enterprises.  Who would have thought in the 1960s that General Electric and General Motors would, by the end of the century, be earning more profit from their financial wings than from their manufacturing capacities?

Another macroeconomic idea that I have repeatedly used in discussing international financial arrangements has been that of the “trilemma”.  The “trilemma” analysis concludes that a country can only achieve two of the following three policy objectives: a free international flow of capital; a fixed exchange rate; and the ability to follow an independent economic policy.

Since 1971 when the United States went off the gold standard, many countries floated the value of their currencies in foreign exchange markets.  This had to occur, the argument went, because in the 1960s, capital began to flow freely throughout the world. 

Therefore, if governments wanted to gain the favor of those that worked in manufacturing and the labor unions by conducting a policy of credit inflation to keep unemployment low and, in many countries, housed in their own home, they had to be able to conduct an independent economic policy.  Within this effort, popular pension programs were also expanded to encourage people to retire earlier and governments became a large supplier of jobs to the economy.   

Thus, the value of the currency could be allowed to decline as governments created massive amounts of debt often financed by foreign interests.  Governments were able to keep the pedal to the floor during this period by generating a relatively steady flow of credit to their economies.

And, what was the micro-impact that the “trilemma” models did not pick up?  It was the declines that occurred in labor productivity that made many nations uncompetitive in world product markets. 

Here we see Greece…and Spain…and Ireland…and Portugal…and Italy…and, others...

And, corporate interests in the United States…and elsewhere…have lots of cash available…either on their balance sheets…or through financial markets that have been generously supplied by the Federal Reserve.

“At Kohlberg Kravis (Roberts), Nathaniel M. Zilkha, co-head of the special situations group, is expanding his London team to eight, from two, and hoping to take advantage of opportunities in Europe.  The firm is even considering potential investments in the country where the crisis began, Greece, despite headlines warning of a default by Athens or the possibility that Greece may withdraw from the eurozone…

Besides Greece, Kohlberg Kravis bankers have also been looking for deals in Spain and Portugal, where private companies are having a similarly hard time winning new credit or extending existing loans.”

As we see over and over again, the excessively loose monetary policy of the Federal Reserve is not helping the “working people”, those 20- to 25-percent of the labor market that are under-employed.  The Fed’s largesse is going to those that can use the money to “do the deal”.  Now, it seems that the flow of funds is going into the acquisition of assets formerly owned by Europeans.  Earlier, we saw Fed injections creating bubbles in commodity prices and in the stocks of emerging markets.   Even earlier than that, we saw Fed injections creating bubbles in the U. S. housing market and in U. S. stocks. 

The macroeconomic models are becoming less and less useful because the world works at a more micro-economic level.  It is at this micro-economic level that we can really observe the complexity of human behavior and also see how markets can self-organize and emerge to take on a life of their own.  Until governments become more sophisticated in their analysis of economic problems, they will continue to create opportunities that the wealthy and the better connected can take advantage of.  And, a Fed guarantee that short-term interest rates will remain at levels that are close to zero only exacerbates the situation.      

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.  

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.

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.