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.

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!

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

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.

Bring on the Debt Restructuring in Europe

Did you hear the latest one…94% of college professors in the United States believe that they are better teachers than the average college professor! Furthermore, the vast majority of college professors also believe that they are better researchers than the average college professor!

I just thought of this when a quote in the Financial Times this morning. The columnist Gideon Rachman writes of the European leaders: “European leaders do not know whether to be more frightened of the bond markets or of their own voters.” (http://www.ft.com/cms/s/0/38e83edc-4e70-11e0-98eb-00144feab49a.html#axzz1GaG5raM7)

In the first case, the European nations do not seem to be able to create any workable plan to bail out the sovereign nations whose debt is under attack by those nasty “speculators” in the bond markets. In the second case, more and more elected officials, like German chancellor Angela Merkel, French president Nicolas Sarkozy, and others, are under pressure from the voters in their countries to adopt “much harder-line policies on everything from immigration to European spending.”

There is a real possibility that Europe could move much more to the right, politically, than has been the case for a long time. Two countries provide vivid examples of this possibility: the Netherlands and England.

The reason I included the little bit of humor in the first paragraph above is that I needed an example of the fact that not everyone can be above average (except in Lake Wobegon). To be honest, there are a lot of horrible college teachers. And, there are a lot of horrible (peer reviewed) research papers written by college professors.

And, not every country (or business or individual) in the world can “pump up” its economy through fiscal deficits and create more and more and more debt.

Someone has to buy the debt and countries and businesses and individuals will not always be available to run fiscal surpluses so as to acquire this debt for their portfolios.

I know this sounds like heresy, but there ultimately comes a day of reckoning for those that issue excessive amounts of debt. I know that the meaning of the term “excessive” is in the eye of the beholder, but, how the financial markets decide what is “excessive” can be cumulative.

That is why we talk of a “debt deflation” and a “credit inflation.” In periods of “credit inflation” the taking on of risk accelerates during the buildup and leverage increases. In a “debt deflation” people cumulatively reduce their exposure to risk and they also de-leverage at such times.

We cannot “average” the amount of debt across nations and say that all these nations just have an average amount of debt outstanding: if we average the amount of sovereign debt in Greece and in Ireland with the sovereign debt of Germany and the Netherlands we cannot say that these countries combined will then have the “average” amount of debt outstanding.

Rachman provides the example of the current Franco-German relationship: “A senior EU official in Brussels says that this is not the old Franco-German relationship that was built on a basis of equality: ‘Germany needs France to disguise how strong it is. And France needs Germany to disguise how weak it is.’”

But, the people of Germany do not seem to be buying this and Ms. Merkel is in trouble. Because of this she has been taking stronger and stronger positions in the negotiations within the European Union. And, Sarkozy seems to be trailing the far right candidate in the buildup for next year’s presidential election and has, therefore, been more of a supporter of Ms. Merkel.

Within such an environment it seems almost impossible that a unified political settlement could be reached that would ultimately satisfy the bond markets in terms of a bail out financing package for EU countries. This would take a political union that I just don’t see happening in the present state of the world.

Some of the weak, like Ireland and Greece, do not appear to be willing to submit to the strong, Germany, in the ways the strong believes the weak must act. Thus, the bond markets will not be satisfied.

But, there seems to be a section of the voting public that are saying that they should not be paying for the undisciplined way others have acted in the past. This body of voters appears to be gaining ground as the coherence of their message grows and the confidence in their ability to succeed expands.

As I said yesterday, there seems to be only one path out of this dilemma: the sovereign debt of the fiscally troubled nations must be restructured. (See http://seekingalpha.com/article/258172-are-there-any-leaders-in-europe.)

Bring it on!

G-19 Plus One

“Another phenomenon on display (at the G-20 conference over the weekend) was China’s willingness to continue fighting on its own in the G-20 if necessary.” (See “G-20 skeptics wait for shift in behavior”: http://www.ft.com/cms/s/0/1b5a9a62-3d23-11e0-bbff-00144feabdc0.html#axzz1EcmIs0vg.)


“In the face of determined and often solo opposition from China, the finance ministers did not mention foreign exchange reserves in the list of indicators (to be used in determining economic imbalances in the global economy).”


Actually, the makeup of the G-20 seems to look more like a quadrilateral. At the corners: China; and the United States; and Germany; and the rest.


China seems to be holding its own against the others: Eswar Prasad, former head of the IMF’s China division stated that “With the rest of the G-20 arrayed against it, China still managed to hold its own.” China, more and more, is feeling its rising strength in international policy discussions.


Then there is the United States. Over the weekend we heard comments from Ben Bernanke, Chairman of the Board of Governors of the Federal Reserve System, and Tim Geithner, United States Secretary of the Treasury.


The common thread in the remarks of Mr. Bernanke and Mr. Geithner: the problems connected with the international imbalances are the fault of China…or, everyone else. The United States is not responsible for any of the imbalances that have occurred.


But, people don’t really seem to be listening to “Ben and Tim” any more, a sign of the respect the United States now gets in the world.


Germany, well, Angela Merkel, the German leader, has problems at home. She is perceived as not tough enough and the feeling is that she has sold out to the rest of Europe. Thus, she is trying to re-establish herself and deal from the strength of the German economic position without sounding conciliatory.


And, the rest of the crop? Well, Nicholas Sarkozy has not taken the G-20 leadership anywhere and although he wanted to use it as a vehicle to regain his popularity in France…or anyplace else it seems. His agenda for the year seems to lie in tatters.


The others…there is no mention of them…well, with the exception of words from Brazil from

time-to-time.


There is no real leadership anywhere, and, there is no real current crisis that needs attending.


So, everyone can basically stake out their own claims and gripe about the others.


However, this does not satisfy anybody.


Everyone knows that there are all kinds of financial and economic problems in the world. But, no one seems to be in a position to really drive home the point that something needs to be done about them.


China and the emerging nations in the world are on their own track, economic growth seems to be robust with the prestige of this group on the upswing. Momentum seems to be on their side.


The United States, the eurozone, the UK…the developed world…seems to be experiencing some

kind of a recovery…but…nothing seems to be easy.


And, a worldwide inflation that seems to be picking up steam.


As a result…the shadow of (financial) crisis seems to looming over everything in the western world.


The eurozone has not resolved its problems, either in terms of the sovereign debt issue or the healthiness of its banking systems. Many investors are just hanging around waiting for the next round of the crisis to rear its ugly head. There still is the feeling that some nations are still going to have to write down their debt. The questions there revolve around when this might occur and just how many nations will be involved.


And, with the menace of inflation growing in Europe and the UK, mediocre economic growth is keeping the European Central Bank and the Bank of England on the sidelines with respect to raising short term interest rates. Also, raising short term interest rates might disturb the financial markets.


The United States government has the cloud of a shutdown hanging over its head. And, even if a shutdown is avoided and some reduction in the budget deficit takes place, the country is still looking at a cumulative increase in the amount of government debt outstanding in excess of $15 trillion over the next ten years. But, the United States still has the reserve currency of the world, and, as long as the United States continues to hold onto this privilege, serious concern over the debt of the government will remain muted. All seems to be posture, there is really no sense of urgency.


Concern still exists in the rest of the world concerning all the reserves the Federal Reserve has pumped into the banking system. The total of commercial bank reserve balances with Federal Reserve banks, a proxy for the excess reserves in the banking system, exceeds $1.2 trillion, a rise of more than $200 billion over the past six weeks. And, the Fed continues to keep its target short term interest rate below 25 basis points and still is not expected to allow this rate to creep up for several months more at the least.


Interest rates in the rest of the world (like in China and Brazil) continue to rise and continue to draw liquid funds from the United States and Europe.


This scenario continues to promise volatility in financial markets. If the global problems are not resolved and the financial imbalances continue to exist, the world will remain unsettled and funds will flow here and there as dramatic movements take place…in financial markets…in commercial banks…in commodities…in whatever markets seem to be the most unstable for the moment.


Is it going to take another major crisis to get action? We had a major financial crisis just a year ago or so and the response to it was pathetic and remains so. Do we really need another one to get people to move?


Here is where China…and Brazil…and a couple of other countries are setting in the driver’s seat. And, the west doesn’t seem to see the situation as a game of chicken. China…and Brazil…and others are not going to blink as long as the United States and Europe continue to drive their midget car against the huge SUV being driven against them. Right now, China does not believe it has to budge from its position. The United States and Europe argue that China is being “unfair”. And, Chinese confidence seems to grow every day. The recent G-20 meeting just reinforces this picture.